It was just another trading day for the Indian rupee on Monday, with the currency closing at 63.87 against the dollar. But its opening on Tuesday morning was quite dramatic, at 64.15, down around 0.43 per cent. This was thanks to the People’s Bank of China deciding to devalue the Yuan.

The Yuan fluctuates two per cent on either side of a reference rate every day. This reference rate was lowered 1.9 per cent on Tuesday and it has been specified that from now on, the reference rate will be influenced by the previous day’s close. The move has shocked financial markets that were factoring in a strong Chinese currency in the near future. China had been following a policy of maintaining a stable and strong currency in a bid to make Yuan one of the reserve currencies of the world. The move to weaken the currency follows the announcement of the International Monetary Fund that it is delaying its decision on whether the Yuan should be included in the basket of reserve currencies.

The other reason behind the devaluation was to give a boost to its sagging exports. “Chinese exports were down eight per cent in July over a year ago,” says Vikram Murarka, Chief Currency Market Strategist, Kshitij. “In an environment where most countries are experiencing slower export growth, other currencies can follow suit.”

According to market experts, the devaluation weakens the environment in financial markets. That the Chinese authorities took such a step shows that the problems within the country are getting serious. While Asian indices closed one per cent lower, European equity markets have got deeper cuts on Tuesday. Most emerging market currencies also lost ground in that session.

How much? Does this mean that the rupee will also have to head lower? According to market experts, any change in the value of Yuan makes the rupee’s value change by 50 per cent (of the change in Yuan).

On Tuesday, the rupee lost 0.3338 paise to close at 64.2.

But while there is a stronger case to allow Yuan to move lower, the case for making the rupee decline is relatively weaker. If we look at the period from January 2011 to now, the rupee has been steadily depreciating against the US dollar; declining 30 per cent in this period.

But the Yuan has been rock-steady in this period and is up 4.4 per cent against the dollar.

REER comparison A comparison of the Real Effective Exchange Rates (REER) of the two currencies also shows that the overvaluation is greater in the Yuan than in the rupee.

REER captures that export competitiveness of a currency against its trading partners.

The real exchange rate of Yuan as captured by Westpac REER is currently at 140. This denotes that the Yuan is overvalued by 40 per cent.

The REER of the rupee on the other hand is 109. While this is above the central bank’s comfort level of 103, the rupee is in no way as overvalued as the Chinese currency.

Depreciation in rupee If this is a one-off change, then the rupee will not be impacted too much.

But, if the Yuan undergoes further decline as a result of the changed methodology of setting the Yuan reference rate, the RBI will have to modify its intervention strategy in forex market to allow rupee to depreciate too. This might not matter too much currently, as rupee has been one of the out-performers among the emerging market currencies this calendar.

It is down just 1.8 per cent against the dollar due to healthy real yield and strong capital flows into the country. This has not really helped our exporters.

The RBI has been buying dollars of late, to keep the rupee from appreciating too much and to keep our exports competitive.

There is therefore enough room for the rupee to head lower. Imports getting pricier will not really worry authorities in the current environment of plunging commodity prices.

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