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1.0 INTRODUCTION

The Chinese Yuan’s advances towards the US Dollar’s throne in world finance is a long-term strategic

move. China has big plans for itself, establishing the nation as the world’s superpower. Much has been

gained in that regard by already becoming the world’s biggest market. The US Dollar, however, is not

ready to give up its throne just yet, and the takeover is going to be anything but a quiet affair. Hence,

the coining of the term “Currency War” by US media and all the commotion that ensued every time

China made any change in its Yuan’s position in the foreign exchange market. Fearing the eclipsing of

the US dollar and the Bretton Woods system by a rival financial architecture the US response has been

an attempt to damage the Chinese markets and increase the value of China’s currency. China has

responded through regulations in the market and then quantitative easing of its currency to maintain the

low prices of Chinese manufactured goods and exports.

1. 1 CURRENCY WAR DEFINED

A currency war, also known as competitive devaluation, occurs when two countries actively compete

against each other to achieve the lowest relative exchange rate for each of their own currencies. The act

of competitively devaluating a country’s currency in order to boost exports has been quite common

among export oriented nations since the abolishment of the gold standard. As the price to buy a country's

currency falls so too does the price of exports. Imports to the country become more expensive. So

domestic industry, and thus employment, receives a boost in demand from both domestic and foreign

markets. However, the price increase for imports can harm citizens' purchasing power. The policy can

also trigger retaliatory action by other countries which in turn can lead to a general decline in

international trade, harming all countries. A currency war is really a race to the bottom, whereby one

country after another devalues their currency to gain an export price advantage, creating too much

supply and not enough demand, which elevates the risks of even more anti-growth protectionist

measures.

1.2 US-CHINA CURRENCY WARS

The currency war between US and China cannot be compared to any conventional warfare in terms of

duration and frequency of attacks. Since 2005, it had allowed its currency to gain almost 30 percent in

relation to the dollar, while trying to moderate its increase. It has no definite beginning or end, and

attacks are not certain either. Things become especially complicated when most of the communication

is done from Washington while China remains quiet about its moves. What is crystal clear, however,

are China’s motives. It wants to reach the pinnacle of world power, and its plans for the Chinese Yuan

is three-pronged:

Keep the Chinese Yuan fixed at a low exchange rate to grow exports

Establish the Chinese Yuan as the standard currency in global trade

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Achieve the Official Reserve Currency status from the International Monetary Fund

Making the Chinese Yuan the global currency would also mean the rise of China’s New Development

Bank and the fall of the United States’ World Bank. This would completely shift the world economy

into being dependent on China. China’s own bank would issue loans to nations while the US would be

left powerless on economic terms.

1.2.1 SIGNIFICANT EVENTS

2005: With the global economy doing well, China was able to abandon its dollar peg in 2005, allowing

a substantial appreciation of the Yuan up to 2007, while still increasing its exports. The dollar peg was

later re-established as the financial crises began to reduce China's export orders. US executives spoke

out against “unfair trade practices” by China.

2009-2010: For much of 2009 and 2010, China has been under pressure from the US to allow the yuan

to appreciate. Between June and October 2010, China allowed a 2% appreciation. The fixed peg was

not abandoned until just before the June G20 meeting, after which the yuan appreciated by about 1%,

only to devalue slowly again, until further US pressure in September when it again appreciated

relatively steeply, just prior to the September US Congressional hearings to discuss measures to force

a revaluation.

2015: In August 2015, China devalued the yuan by just under 3%, partially due to a weakening export

figures of -8.3% in the previous month. The drop in export is caused by the loss of competitiveness

against other major export countries including Japan and Germany, where the currency had been

drastically devalued during the previous quantitative easing operations. It sparked a new round of

devaluation among Asian currencies, including the Vietnam dong and the Kazakhstan teng. The

devaluation sparked fears of a global "currency war" and accusations that Beijing was unfairly

supporting its exporters.

1.2.2 CURRENT SCENARIO

Beijing announced that it had bought 600 tons of gold in the span of a month and the People’s Bank of

China had got rid of over 17 billion US dollars from its foreign exchange reserves. The yuan still only

accounts for 2.06 percent of global transactions, according to Swift. But that's up from 1.39 percent a

year ago as it leapfrogged both the Canadian and Australian dollars. And as recently as January 2012,

the yuan was the 20th most-used currency, not the fifth. If the U.S. is the loser in the currency wars,

China is likely to be the long term winner. Some analysts are predicting a 10 per cent devaluation of

the yuan in the coming year, which is an important tail risk given weakness in the euro and yen.

While rumours of the dollar's demise as the world's reserve currency of choice have been greatly

exaggerated, the U.S. has lost some ground. It still has a dominant 62 percent share of global currency

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reserves, according to the International Monetary Fund, though that's slipped from more than 72 percent

in 2001.

From the US perspective, abolishing the long established institution which they found so long and hard

for is a crime.

1.3 WHY IS WALL STREET WORRIED?

1. China's move suggests that its economy is in worst shape than believed. It highlights the

fragility of the global economy.

2. A weaker yuan means a stronger dollar, and a stronger dollar means U.S. products sold in China

are more expensive, which means fewer sales of Apple iPhones, hotel rooms offered by Wynn

Resorts and computer chips made by Micron Technology.

3. There is a fear that other nations will respond to China by devaluing their own currencies to

stay competitive. Currency wars are anti-growth and deflationary.

2.0 LINKING INTERNATIONAL FINANCE THEORIES TO US-CHINA CURRENCY WARS

2. 1 PURCHASING POWER PARITY (PPP) THEORY

Purchasing Power Parity (PPP) Theory suggests that when a country’s inflation rate rises, the demand

for its currency declines as its exports decline (due to its higher prices). In addition, consumers and

firms in that country tend to increase their importing.

This theory can be related to the scenario of China’s devaluation. The recent economic slowdown in

China, as suggested by the article, has caused China to devalue Renminbi. China wanted to devalue its

currency in order to lower the inflation and boost economic growth. With the decrease of economic

activity the inflation rate is supposed to decrease leading to further appreciation of home currency (or

devaluation of foreign currency). The graph below illustrates the theory:

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For simplicity let’s assume that China was on the PPP line, point 4,4. With the decrease of inflation rate

differential (due to decrease of home inflation as a result of economic slowdown) from 4,4 point to 4,2.

This is because the Chinese Yuan is pegged against dollar but not floating. To maintain the parity, China

is required to devalue the currency in order to avoid disparity between exchange rate and inflation rate

differential.

2.2 INTERNATIONAL FISHER EFFECT (IFE) THEORY

A major theory in international finance, the International Fisher Effect theory, suggests that the spot

rate of one currency with respect to another will change in accordance with the differential in interest

rates between the two countries. Consequently, the return on uncovered foreign money market securities

will, on average, be no higher than the return on domestic money market securities from the perspective

of investors in the home country due to offsetting effect. For the purpose of understanding how

international fisher effect is relevant to the currency war between China and USA, we can consider the

following graph:

We assume that prior to the commencement of the currency war a US investor was operating at a point

on the IFE line, for example (3,3). Due to the initial devaluation of Yuan, the investor moved to a point

above the IFE line (1,3) which would yield him lower returns from foreign deposits than earned

domestically. However, in light of People’s Bank of China getting rid of over 17 billion US dollars

from its foreign exchange reserves, there will be an excess supply of US dollars in the market which

will create a downward pressure on the US interest rate, pushing it down to (1,1).

One of the options that USA can consider to salvage its economy at this point is to increase the domestic

interest rate. This will inevitably increase the interest rate differential between the two countries and

restore it back to original levels.

An investor from a different country will be tempted to invest in China immediately after the

devaluation of Yuan because, once converted to their home currency, it will result in greater returns. If

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USA does indeed increase their interest rate in response to China’s devaluation, investors from other

countries will perhaps move their investments from China to USA.

The devaluation has led the economies in the brink of a currency war as suggested by the speech of

Jannet Yellen, who said rates could be raised at the meeting to be held in October, despite the fact that

there is no press conference scheduled for that meeting at this time. The last time the Feds have

interfered with the interest rate was in the year 2008 during the recession, the harsh measure was

necessary to take as the economy was shattered. However with the end of such catastrophe and

beginning of revival, the Fed has the scope to hike the interest rate.

Such currency war may not be a harbinger of good news. Continuous change in the exchange rate and

interest rate may cause the investor to lose confidence to invest in these two countries. The war between

the two largest economies will depress the investment markets global. In addition, the investors who

invested fixed assets in these two economies will lose confidence as repatriation of profit will be a big

question which will shake their confidence.

3.0 EFFECTS OF THE DEVALUATION AND WHERE IT IS HEADED TO

China's decision to devalue the Yuan against the US dollar reflects concerns about the weak

performance of the Chinese export sector this year. The sector has faced a perfect storm of sluggish

global demand for its exports and eroding competitiveness due to rising Chinese manufacturing wages,

as well as the depreciation of the euro, yen, and many other emerging markets' currencies against the

US dollar this year.

With the US Federal Reserve expected to begin lifting its policy interest rate soon, which would have

put further downwards pressure on the euro, yen and emerging markets' currencies, pressure had built

up for the Chinese government to allow the yuan to move lower against the US dollar before the Fed

rate hike.

Although President Xi and Premier Li Keqiang have made economic reforms and a transition to

domestic demand-led growth policy priorities, the sharp economic slowdown and stock market crash

have forced them to take measures to stabilize the Chinese economy. The export sector has been a key

growth engine for the economy. While China will continue to make a gradual transition from an

economy driven by investment and exports towards an economy driven by domestic consumption, this

transition will take many years. Meanwhile during the current cyclical slowdown, the government is

again having to resort to boosting its traditional growth engines of investment and exports to try to

stabilise the economy, using its toolbox of currency devaluation to improve export competitiveness,

and fiscal and monetary stimulus to boost domestic demand.

The Chinese yuan devaluations have created turmoil in currency markets, with many other emerging

markets' currencies also depreciating against the US dollar following the yuan devaluations. The

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stability of the CNY against the US dollar in recent years has helped to mitigate risks of competitive

depreciation among emerging markets' currencies, with the CNY acting as an anchor of stability in

currency markets. However, if the CNY devaluations this week herald further such devaluation steps

by the Chinese central bank, it could increase uncertainty and turmoil in global currency markets,

particularly if the Fed also begins hiking interest rates.

The depreciation of the euro, yen and many emerging markets' currencies against the US dollar over

the last year had put pressure of China to also devalue its currency against the US dollar. However, in

an environment of sluggish global growth ... the Chinese devaluation has triggered a shock wave of

further depreciation among many emerging markets' currencies. The net effect is that China's relative

competitiveness against many other emerging markets has not changed significantly after its

devaluations.The US dollar has already appreciated significantly against many of the currencies of its

key trading partners, including the euro and the yen, as well as many emerging markets' currencies.

Consequently, US export competitiveness has been gradually eroded by the strengthening US dollar as

prices get higher.

The Chinese yuan devaluation will further erode US export competitiveness, not only in the Chinese

market, but also in other emerging markets as a result of the latest round of emerging market currency

depreciation. However, many US multinationals will be resilient despite the strong US dollar, as they

have extensive production facilities and supply chains in the EU and emerging markets that act as a

hedge against US dollar appreciation. For the eurozone economies, the significant depreciation of the

euro against the US dollar over the last year has improved the competitiveness of EU exports into the

key US market. As the Fed begins raising interest rates, this is likely to result in further appreciation of

the US dollar against the euro, helping to improve eurozone export competitiveness in the US market.

With the US Federal Reserve expected to begin lifting its policy interest rate soon, which would have

put further downwards pressure on the euro, yen and emerging markets' currencies, pressure had built

up for the Chinese government to allow the yuan to move lower against the US dollar before the Fed

rate hike.In the US, where politicians have long accused China of manipulating its currency unfairly,

senior lawmakers from both parties are positioning the devaluations as China grappling for an advantage

in its exports. Yet the International Monetary Fund (IMF) called the depreciations "a welcome step",

arguing that they allow the yuan's value to be better determined by the market, and not by its relationship

to the dollar.

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APPENDIX

Figure 1 RNB's record low devaluation

Figure 2 Yuan Ranks 4th according to latest IMF declaration

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Figure 3 China is declining its US Reserves Holdings

Figure 4 US-China Trade (2002-2014)

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REFERENCES

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(2015). The Fed's plan to hike interest rates. The Economist.

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explains-21

(2015). Federal Reserve puts rate rise on hold - as it happened. The Guardian.

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interest-rate-decision-markets-janet-yellen-live

Anderlini, J. (2015). Surprise China devaluation marks escalation of currency war.

Financial Times.

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87c7270955cf.html#axzz3tT2YLMdU

Madura, J. (2008). International Corporate Finance. Florida Atlantic University. 10th

edition.

Nazemroaya, M. D. (2015). Washington’s Financial Currency War on China: The

Eclipsing of the US Dollar by the Yuan. Global Research.

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eclipsing-of-us-dollar-by-yuan/5473064

(2015). The US-China “Currency War”: Winners and Losers. Counter Punch.

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winners-and-losers/

Gulber, A. (2015). Currency war in China or market forces at work? Market Watch.

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work-2015-08-25

Sweeney, P. (2015). China lets yuan fall further, fuels fears of 'currency war'. Reuters.

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Retrieved from: http://www.reuters.com/article/us-china-markets-yuan-

idUSKCN0QG04U20150812#wT2K1yCU5zqsRKHp.97

Khan, M. (2015). Global currency wars: why China's devaluation is a peace offering

misunderstood by the world. The Telegraph.

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stock-market

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August 11, 2015 11:12 am

Surprise China devaluation marks escalation of

currency war

By Jamil Anderlini in Beijing

According to conventional wisdom, wars are easy to start and difficult to end. Similarly

Beijing’s devaluation, the biggest one-day currency move since 1993, represents the latest

skirmish in an emerging battle which, analysts warn, may be hard to reverse.

The move marks a shift in China’s historical policy during times of economic stress. In the late

1990s, the country was widely credited with containing the destruction from the Asian financial

crisis because it held fast to the renminbi exchange rate in the midst of competitive devaluations

throughout the region.

In the global financial crisis of 2008, Beijing also refused to devalue even as its exports, a key

driver of the economy, evaporated overnight.

But now, in the midst of a pronounced and persistent Chinese economic slowdown and

continued appreciation pressure resulting from the renminbi’s “dirty peg” to the soaring US

dollar, China’s leaders have decided to take the plunge.

“This shows how desperate the government is over the state of the economy,” said Fraser

Howie, a China analyst and co-author of RED CAPITALISM. “If they were trying, as the

central bank said it was, to bring the exchange rate back into line with market expectations then

they have failed miserably as the market is now just expecting further devaluation.”

In its announcement of the devaluation just before markets opened on Tuesday morning, the

People’s Bank of China went to considerable lengths to insist this was a one-off move and part

of a broader shift to a more market-orientated exchange rate mechanism.

The PBoC said it would calculate the daily renminbi fix — the rate it sets the currency each

morning and from where it is allowed to move as much as 2 percentage points in either direction

— by taking more notice of market forces, including movements in global currency markets.

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“The People’s Bank of China has orchestrated a clever combination of a move to weaken the

renminbi with a shift to a more market-determined exchange rate, blunting foreign criticism of

the renminbi devaluation,” said Eswar Prasad, the former IMF country head for China.

“China’s move will reverberate in global currency markets and signals that one of the last

holdouts among the major economies may be throwing in the towel and joining the fray in

trying to use currency policy as a tool to counter weak growth.”

Virtually all analysts agree that a revival of China’s declining exports will require a much more

significant depreciation than Tuesday’s “one-off” move.

Tom Orlik, Bloomberg chief Asia economist, estimates a 1 per cent depreciation in the real

effective exchange rate boosts export growth by 1 percentage point with a time lag of three

months.

But the renminbi’s inflation-adjusted, trade-weighted exchange rate against all currencies was

up 3.6 per cent in the first half of this year and up 10.3 per cent since the start of 2014, according

to figures from the Bank for International Settlements. As recently as last month, numerous

senior officials and government experts were insisting that China would not devalue the

renminbi.

In late March, Chinese Premier Li Keqiang told the Financial Times: “We don’t want to see

further devaluation of the Chinese currency, because we can’t rely on devaluing our own

currency to boost exports.

“We don’t want to see a scenario in which major economies trip over each other to devalue

their currencies,” Mr Li continued. “That will lead to a currency war, and if China feels

compelled to devalue the RMB in this process, we don’t think this will be something good for

the international financial system.”

The change in official thinking in the months since the premier all but ruled out Tuesday’s

move comes as China’s economy slowed a lot more than Beijing expected. Exports, in

particular, have declined, following an 8.3 per cent year-on-year drop in July.

Last month’s bursting of a year-long equity market bubble and the government’s scramble to

prop up stocks further unnerved China’s leaders and appear to have convinced them to break

the longstanding taboo of devaluation.

Apart from the danger of a currency war with other countries, Beijing must also be wary of

political pressure from Washington where the perceived undervaluation of the renminbi has

been a constant source of trade friction.

Another problem is that depreciation is likely to exacerbate capital flight, which has already

become a serious issue this year for the first time in more than a decade.

“The devaluation in the renminbi is not large enough to improve China’s export

competitiveness, but it is large enough to create a sense that Beijing may have fundamentally

shifted its currency policy,” said Stuart Allsopp, head of country risk and financial markets

strategy at BMI Research. “The risk now is that investors see the yuan [another term for the

renminbi] as a one-way bet weaker and start to position against the currency, raising the

prospect of more substantial yuan weakness and more economic uncertainty.”