Will yuan devaluation, lower inflation prompt RBI to expedite rate cut?

The dollar is already strengthening against the euro on the back of a weak euro region brought about by the Greece crisis. The Chinese move will only aggrandise the same.

Madan Sabnavis August 12, 2015 21:56:33 IST
Will yuan devaluation, lower inflation prompt RBI to expedite rate cut?

The rupee has been fairly stable in the region of 63.75 in the last few weeks with FII flows being positive and the only disturbance being caused by the news of the US Federal Reserve increasing interest rates.

However, on the 11 August the People's Bank of China delivered a shocker by devaluing the yuan or renminbi by 1.9 percent. Under the new dispensation the rate will be allowed to move in a band of 2 percent from the benchmark which will be determined by the closing rate on the previous day.

Will yuan devaluation lower inflation prompt RBI to expedite rate cut

The RBI logo. Reuters

This move has created havoc in the global economy with the currency markets and stock markets responding with high levels of volatility in the downward direction. What is this all about?

China has always been accused of having an undervalued currency in the sense that with high capital flows the yuan should have been typically appreciating. This is what theory says. However, China has not allowed the yuan to strengthen in a bid to retain competitiveness of its exports.

This was considered to be an unfair practice causing countries like the US to lament as their own exports tended to lose out. In simple terms, if the yuan is not allowed to appreciate when it should be moving in that direction, the dollar value of huge goods is kept low indirectly, thus pushing up exports.

China now has gone one step ahead and depreciated the yuan which straight away gives it an export advantage at a time when the world economy is struggling to get on its feet. With growth in global trade slowing down significantly, the market is narrow with low growth impulses from the developed countries in particular.

Under these conditions, making the yuan weak exacerbates the situation. However, China has argued that it has only aligned the currency to the market conditions and with the economy slowing down significantly with all estimates being in the range of 7 percent for 2015. Therefore, the argument goes that it is doing the right thing which is normal under these circumstances as a weak economy should cast its shadow on the currency which should weaken in turn.

However, the consequences are serious. As the depreciation is an export strategy it stands to reason that all exporting nations will be compelled to follow suit and let their currencies fall to retain their exports shares.

This is the classic case of a currency war where competitive depreciation or devaluations will be attempted by countries either directly or covertly. Hence the fear of the emergence of the infamous 'beggar my neighbour' policies could be back in vogue as was the case during the Great Depression of the 1930s where devaluation was used to push up exports, which in turn pauperised the other nations who perforce had to follow suit.

The major impact is on the US, which will be affected the most in the exports market. It will have to take a call on how it can counter this move.

An immediate fallout could be that the Fed may defer the rate hike because by keeping rates low, one can keep inflows out and retain a weak currency. By increasing rates, which was the original plan, funds would get diverted back to the USA thus strengthening the dollar.

The dollar is already strengthening against the euro on the back of a weak euro region brought about by the Greece crisis. The Chinese move will only aggrandise the same.

The same is the implication for India. The RBI will come back into focus on two counts. The first is that it can accelerate the process of further rate cuts which were expected in the August policy. This is so because besides inflation, which is under control with the latest CPI number coming at less than 4%, there is need to keep foreign funds at a lower level so as to let the rupee weaken.

The second is a conundrum for the RBI as we get back to the old syndrome of market guessing the RBI's moves. The rupee has already fallen to close to Rs 65 a dollar and until the RBI comes up with some action or statements, the currency will remain volatile.

At any rate any downward movement spells trouble for Indian companies which have unhedged exposures which has been a recurrent problem for them in the last three years or so. Therefore, the RBI once again has to take proactive steps on the rupee to ensure order that is in line with fundamentals while keeping tuned to global influences. At the same time, it has to probably expedite the rate cuts that industry has been clamouring for in the last few months.

Therefore, the next few days will be volatile for both the rupee and the stock market which will be waiting for direction to be provided by global cues as well as the RBI. The good part is that the latest IIP growth number for June and CPI inflation for July are good which offers the comfort of a cushion on domestic fundamentals.

The author is chief economist, Care Ratings. Views are personal

Updated Date:

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