- By Vivek Kaul
The Dow Jones Industrial Average started the day on August 24, 2015, around 1000 points down, from its previous close on Friday (August 21, 2015). It recovered more than 800 points and then started to fall all over again. Ultimately, it closed the day at 15,871.28 points, down 588.47 points or 3.58%, from its previous close.
Earlier in the day, the Shanghai Composite Index was down by 8.5% to close at around 3,209.91 points. The BSE Sensex also saw a massive fall of 1,624.51 points or 5.94% to close at 25,741.56 points. Stock markets around the world fell.
Analyst after analyst has blamed China for this massive fall in stock markets all over the world. And so have politicians. Before I get into this, here is some background. Until August 10, 2015, around 6.2 Chinese yuan made up for one US dollar. Between August 11 and August 14, the People's Bank of China, devalued the yuan against the dollar. Since then the value of the yuan has moved between 6.38-6.40 yuan to a dollar. This was the biggest devaluation in the value of the yuan in two decades.
The yuan has been devalued in the hope of getting Chinese exports going again. In July 2015, the Chinese exports fell by around 8.3%. The fear is that the Chinese will continue to devalue the yuan in the days to come to prop up their exports.
A devalued yuan will lead to cheaper Chinese exports. Let's understand this through an example. Let's say a product exported out of China is sold at $50. At around 6.4 yuan to a dollar, the exporter makes 320 yuan every time he sells one piece of the product. We assume no other expenses for the ease of calculation.
Now let's say the Chinese gradually devalue the yuan to around 7 yuan to a dollar. Then for every piece of the product that is sold the Chinese exporter makes 350 yuan. Instead of taking on the entire gain, the exporter may decide to cut the price in dollars and make his product more competitive. Let's say he cuts the price of his product to $46. At this price he still makes 322 yuan, which is a little more than the 320 yuan he was making earlier. Nevertheless, given that he has cut his price by a significant $4, chances are he will sell more pieces of the product and make more money in the process. Chinese exports will go up and this will perk up economic growth as well.
Data from 2014 shows that China exports nearly 63% of its exports to the developed world (i.e. United States, European Union, Hong Kong, Japan, South Korea, Russia and Taiwan). Prices of products made in these countries would have to be cut, in order to compete with similar products which are made in China and exported to these countries.
This would lead to prices falling (or what economists like to call deflation) in these countries and that can't be good for the overall economy. The stock markets are adjusting to this "new reality". The Economist estimates that "more than $5 trillion has been wiped off on global stock prices," since August 11, the day China first devalued the yuan against the dollar.
China has been largely blamed for this massive fall in stock markets all over the world. It is being said that China will export deflation to other parts of the world.
In fact, even Donald Trump, who is a Presidential candidate for the Republican Party in the United States, has an opinion on this. Speaking to reporters after the Chinese started devaluing the yuan he had this to say: "I think you have to do something to rein in China. They devalued their currency today. They're making it absolutely impossible for the United States to compete, and nobody does anything. China has no respect for President Obama whatsoever, whatsoever.
Well, you have to take strong action. How can we compete? They continuously cut their currency. They devalue their currency. And I have been saying this for years. They have been doing this for years. This isn't just starting. This was the largest devaluation they have had in two decades. They make it impossible for our businesses, our companies to compete.
They think we're run by a bunch of idiots. And what's going on with China is unbelievable, the largest devaluation in two decades. It's honestly - great question - it's a disgrace."
Economist John Mauldin had this to say regarding Trump's comment on the devaluation of the yuan: "Before you dismiss this as nonsense, remember that it comes from a Wharton School graduate." These MBAs I tell you.
The larger point is why is everyone blaming China for the massive stock market crash all around the world? What led to China letting its currency fall a little against the dollar between August 11 and August 14, 2015? Now that is a question worth asking and answering.
In October 2012, around 80 yen made up for a dollar. Since then, the Bank of Japan has been printing yen (or rather creating them digitally) to drive down the value of the yen in a bid to make Japanese exports more competitive and Japanese imports more expensive.
The idea was that if Japanese exports became more competitive on the price front (as a result of the devaluation of the yen, as we saw with the yuan example earlier), the total amount of Japanese exports would go up. At the same time, if Japanese imports became more expensive, the sale of goods produced locally would go up.
This would mean that exports as well as consumption of goods produced within the country would go up. And this would benefit the Japanese economy. As William Pesek recently wrote on Bloomberg.com: "The yen's 35 percent drop since late 2012 made Japanese goods cheaper, companies more profitable and Nikkei stocks more attractive." Further, with a fall in the value of the yen, Japanese exports became more competitive in comparison to exports from countries like Taiwan and South Korea.
Further, imports into Japan became more expensive and this hit countries like China. The Chinese exports to Japan fell by more than 10% in July 2015. By trying to devalue the yuan, China was only doing what the Bank of Japan has been doing for a while.
Other than the Bank of Japan, the European Central Bank, the central bank of the euro zone(essentially countries which use the euro as their currency), has also been printing money, in the hope of driving down the value of the euro. The ECB is printing around 60 billion euros a month.
As Mauldin points out: "First off, the two largest currency manipulating central banks currently at work in the world are (in order) the Bank of Japan and the European Central Bank. And two to four years ago the hands-down leading manipulator would have been the Federal Reserve of the United States...Today, the euro is off over 30% from its highs,as is the Japanese yen. Numerous other currencies are likewise well into double-digit slides. China has moved maybe 3 to 4%. Oh, wow."
Also, it needs to be pointed out here that the Chinese yuan had been rising against the dollar, all this while, unlike what Trump pointed out. As Mauldin writes: "The rest of the world (Japan, Europe, Great Britain, Brazil, India, among others) [has been] letting their currencies drift down. The simple fact is that the Chinese currency rose by 20% over the last five years...It is utterly wrong-headed to call a 20% rise over almost 10 years "continuous devaluation."
Hence, why blame only China? The currency wars are on, and China is just one part of it.
Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.