As I came in from my walk yesterday, I saw some little girls playing their usual, chirrupy games…

Ring-a Ring-a Roses

Pocket full of posies

Atishoo! Atishoo!

They all fall DOWWWWWNNNNNN!!!

There was a great amount of scuffling and giggling to make sure that one sits down before the others. A competitive, let-me-fall-before-you-do game. The person to fall last gets a penalty, of course. I sat down on a bench to watch them play, and Econ Mom took over. Obviously.

The day’s news were playing on my mind. It’s almost similar, I found myself thinking. The ring-a-roses on the currency markets today. The yuan sneezes…Atishoo! And they all fall down in a competitive depreciation. The Rupee and the Yen and the Ringitt. The question is: WHY did the Yuan sneeze? Here are some quick Q&As.

#1. I hear that the Yuan devaluation has to do with Special Drawing Rights? What are SDRs?

Simply put, the SDR is an international reserve asset created by the IMF, which can be used to supplement or augment the member countries’ official reserves. Now this reserve asset comprises of 4 currencies; the dollar, the euro, the pound and the yen. 2015 is the year in which the IMF will review whether new currencies should be included in the pool of currencies that comprise the SDR.

There are 2 basic features that a currency has to posses to make it to the highly dignified SDR category. It has to have a significant role in world trade and it has to be “freely usable”.

That the Chinese have a significant role in world trade is undisputed. Their current contribution to 11% of the world’s exports means that they gain automatic entry into the IMF review this year, though of course, their chief stumbling block would be that the Yuan is not perceived to be “freely usable.”

The Articles of Agreement of the IMF define a “freely usable” currency as that which is widely used to make payments for international transactions and is widely traded in the principal exchange markets. Thus, a freely usable currency is technically NOT a freely floating currency. In fact, it has very little to do with the underlying exchange rate regime. You could have a situation where in a currency was fixed but was freely usable in markets across the globe.

So the next question is: Is the Yuan freely usable? Increasingly so. More and more FOREX reserves are being held in Yuan terms, more and more export payments are being made in Yuan terms. The Economist has shown that even though Yuan payments/ holdings may not be high in absolute terms, its been showing a growth rate that allows it to come very close to the “freely usable” terminology. At least, “The Economist” thinks so.

The People’s Bank of China (PBC) is now in a mood to make sure that the IMF thinks so too. One of the chief reasons why the Yuan was devalued is because the PBC is anxious to prove to the world that the Yuan increasingly is market determined, rather than determined in a fixed parity by the Bank.

#2 Hold on. I thought the Yuan was always undervalued. If the market is to determine it, it should have risen, right?

Wrong. There are 2 factors here. First, that the yuan has been typically held undervalued is a correct perception. However, in the last one year, with the US showing robust fundamentals, the dollar has undoubtedly strengthened. The robust fundamentals and increasing sentiment has also increased the possibility of a rate hike and FIIs hence have been making a beeline towards the dollar, strengthening it further. Since the Yuan, at whatever undervalued level, was held fixed vis-a-vis the dollar, it has implied that the Yuan has de-facto strengthened against most currencies in the globe. So even if the yuan was undervalued, the extent of its undervaluation has lessened. This is one of the reasons that sparked off the devaluation.

Second, the Chinese fundamentals have definitely deteriorated in the last one year, when the US strength has increased. Here is my earlier blog on what plagues their banking structure and why excess capacities got built in China. A deterioration in the fundamentals calls for a devaluation from the present value, whether that value is correct or otherwise to begin with becomes immaterial.

# 3. Does the Yuan devaluation help China? If every Emerging Market goes into competitive depreciation, there’ll be no relative change at the end of the game.

The argument given above is largely a financial argument. As currencies across the globe get hit, relatively we may find in the medium term that the Yuan is not really cheaper compared to the other emerging currencies and hence, Chinese exports may not really get the boost that they want vis-a-vis other emerging markets. But that the yuan stands cheaper vis-a-vis the dollar, is undeniable.

Second, the current movement in the yuan is not so much about devaluation as it is about sending a signal of more flexibility. While the IMF has now said that the same 4 currencies will comprise the SDR till September 2016, there is increasing reason to believe that the Yuan would find a place in the SDRs after 2016. This would make the Yuan more acceptable, more traded and would create a different positioning for China in the global markets.

Epilogue:

As every News Channel was analyzing yesterday, the currency market movements are because of the SDR issue. Never in my life do I remember the humble, modest SDRs occupying such a special place in a common man’s life and discussions. To have news analysts yelling about Sensex and currencies was okay, but to have them yelling on composition of SDR, the IMF’s virtual currency, the role of which IMF itself says has been “insignificant”, was surprising beyond measure.

As I got up from the bench with a sigh to head back home, I heard the girls start on their game…

Who stole the cookies from the cookies pot? Who me? Yes, you. Couldn’t be. Then who? Mr. Yuan stole the cookies from the cookies pot.