“The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists” – Ernest Hemingway
Global economy is a complex ecosystem of multilateral trade, currency, resources, people (Human capital), and other key indicators that determine a country’s strength in the marketplace. Each of these factors are intertwined with one another in both local and global context. Although these factors are not entirely in human control, central banks and governments can – to some extent – impact changes through policy decisions. Any changes in the perceived or actual value of a factor will ripple across the ecosystem and affect the economy as a whole. Apart from the measured forces (factors) in an economy there are few unknown forces that can only be predicted, forecasted, or assumed – for example, positive market sentiment when government is actively pushing pro-business reforms.
Devaluation of a currency, in simple terms, means that the intrinsic value of a unit of currency has decreased. For example, When INR is devalued, the amount of products/ goods/ services that 100 INR bill can purchase decreases. This leads to: inflation in home economy as purchasing power of 100 INR bill decreases, increase in petrol (and other petrochemical products) prices as imports become costlier, increase in fiscal deficit due to high import costs. The consequences are not just limited to the shores of domestic economy, they are observed in distant economies too. Why does this happen?
In these times of globalization, every country is out in the market to buy commodities, goods, services, financial instruments, etc. from a country that offers the best price; and to sell domestic goods at a competitive price to increase its global market share. In this process of buying and selling (imports and exports respectively if you like) between countries, the transaction is made by exchange of currencies. Higher the value of home currency, more products can be bought, and (more importantly) less products or services can be sold because higher value of currency makes it expensive for others to buy. Hence they will search for cheaper alternative if available.
In order to understand this better let’s examine how the Aug 2015 devaluation of Yuan ( Chinese currency, also called Renminbi ) has send shockwaves across all developed and developing nations.
Over the past three decades Chinese economy has grown more than four-and-half times that of India in the same period with exports being the main driver of growth. Due to anticipation of US interest rates rise, US dollar has appreciated pulling along Chinese Yuan as the latter loosely tracks dollar making Chinese exports dearer compared to regional competitors. Low industrial production, fall in factory gate prices, plunge in stock markets, and rising fears of slowdown in growth have made it imperative for Chinese authorities to push reforms and stimulate economy. People’s Bank of China responded to this apparent crisis by devaluing Yuan against dollar which resulted in nearly 3% depreciation and biggest one day fall in 20 years.
While China has taken these steps to trigger fresh stimulus in order to meet its goal of above 7% GDP growth, it has caused the following repercussions around the world:
- Markets in Shanghai closed 8.5% down – worst single day fall in 8 years.
- Nikkei index in Japan slipped by 4.6%
- European bourses were down 4-5%
- Dow Index was down 4 %
- Emerging market currencies are tumbling
- Index of 22 Commodities compiled by Bloomberg is at its lowest since 1999
- Oil price has hit a six-and-a-half-year low
(The above observations are taken from an article published in The Economist under Business and Finance section. It can be referred here for more information.)
This type of reaction is not same for every economy. It highly depends on country’s position in global trade, state of global economy, and over dependence on a particular economy. Many a times such reaction is a combination of multiple factors ranging from growth outlook to international monetary conditions.
In conclusion, any change in macroeconomic indicators of an economy will have its impact on the region, and sometimes on the whole world depending on the state of economy.
- Why China has devalued renminbi and how it will affect the UK
- The Effects of Currency Fluctuations on The Economy
- Economic effect of a devaluation of the currency
- Why has China devalued its currency and what impact will it have
- The causes and consequences of China’s market crash
- Eight reasons why China’s currency crisis matters to us all
- How China’s currency devaluation could raise prices in the US
Source of image: https://www.flickr.com/photos/bradipo/1435739708