The surprise devaluation of the Chinese Yuan by 2% on late Monday created nervousness among the global markets. Not surprisingly, Indian markets too responded with nervousness on Tuesday as the INR weakened below the psychological Rs.64/$ mark and the equity markets lost 3/4th of a percent. To be fair, China did not actually devalue the currency. It only made its benchmark methodology more market-driven and changed the mid-point, which had the effect of a 2% devaluation of the Yuan. The key question is, why does Chinese Yuan devaluation spook the global markets in general and Indian markets in particular?
There are three key reasons for the same. Firstly, China is the world’s largest exporter and accounts for close to 14-15% of world exports. Yuan devaluation gives China a disproportionate advantage in increasing its export market share. Secondly, China is also the world’s largest importer. Commodity producers like Australia, Indonesia, Canada and Africa rely substantially on China as the world’s largest market for commodities. Yuan devaluation would make such exports to China more expensive at a time when they are already facing contraction of Chinese demand. Last, but not the least, global markets are fearing an all-out currency war with most nations like Japan, Europe and Brazil having already seen a sharp currency devaluation over the past year due to a cheap-money policy. But then why is this devaluation so critical for India?
India runs a massive trade deficit with China
India’s annual trade deficit with China was nearly $48 billion. That is about 60% of the total Indo-China trade, as compared with 90% in the case of many European nations. But that is off the point! The worry for India is that China alone accounts for 40% of India’s total trade deficit and this number has grown sharply by 33% in the last one year alone. A devaluation of the Chinese Yuan would typically have a multiplier effect on the deficit. This also puts pressure on the forex currency reserve of India; which at $350 billion is less than 10% of China’s reserve of $4 trillion.
Dumping worries for steel, tyres and heavy equipment
Ask any manufacturer of steel or tyres about their biggest business worry and it would obviously be China. Helped by government subsidies, China has been able to manufacture most of the above products at much lower cost than India. For example Chinese tyres are 30% cheaper than Indian tyres and they already have a 25% market share of truck radials in India. Devaluation of Yuan will make these Chinese tyres cheaper and their market share larger. Similarly companies in the steel and heavy machinery segment have been badly hit by cheap Chinese imports. They could see a visible dip in their market share.
Currency wars and capital flows
The bigger worry for India will be in the realm of capital flows. India has typically seen sharp capital outflows whenever currency depreciation is expected. We saw that in 2008 and again in August 2013, when an anticipated depreciation of the rupee led to a surge of capital outflows. As India relies substantially on capital inflows to bridge its fiscal deficit, this is a real area of concern for India. The RBI has been successful in keeping the currency stable within a band for over 2 years, which has encouraged portfolio inflows since 2014. They would not want to lose out on this privilege. The second worry for India is that China is now trying to open up its financial markets to global investors. After the $4 trillion value white-wash and portfolio outflows, China would be keen to attract foreign money back into China. Devaluation could make that decision more attractive for foreign investors.
What should India do?
Honestly, there is not much that India can do as a direct response to this measure. Currency valuations are a matter of national sovereignty and China has only exercised the same. India has already raised customs duty on steel products, but there is only so much that trade barriers can contribute. On the one hand, it may have to avoid cutting interest rates and increase the debt limit for FIIs so that the portfolio inflows keep coming. From a slightly short-term perspective, India needs to immediately focus on its export basket and stem the 7-month fall in exports with necessary incentives. Fast-tracking FDI may be another method but that is something that will yield results over the medium to long term. The message for Corporate India seems to be clear; With China at the gates, it is time to shape up!
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