A Weaker Yuan Can Challenge India's Export Competitiveness

There's speculation that a yuan devaluation could be the next risk event for India, posing structural headwinds for the rupee by threatening India's export competitiveness.

So far this year, the Chinese yuan has weakened by over 100 basis points before it recovered slightly. A dollar currently buys around 7.2 yuan.

Weakness in the yuan is linked to the Japanese yen's plunge to a 34-year low this year. The yen, the third-most traded currency in the foreign exchange market, has shed about 8.6% against the dollar since Jan. 1.

"As such, there is a risk of the Chinese currency weakening from here, given that the Chinese yuan and the Japanese yen are competing currencies," said Dhiraj Nim, FX strategist and economist at ANZ. Given Chinese manufacturing capacity and exports, the Chinese authorities would not like an appreciated currency via-a-vis the Yen given the trade competitiveness between both economies, he explained.

The last time the Chinese authorities devalued the yuan was in August 2015 by 4.7% against the dollar.

So far, the Chinese yuan has remained stable against the Indian rupee, possibly amid Reserve Bank of India's intervention to stabilise the local unit. However, any devaluation in the yuan will have repercussions, Nim said. "China's devaluation of the yuan will pose a structural concern to the rupee, not just a cyclical concern."

"How the impact unfolds will also depend on whether the Chinese authorities allow a single sharp devaluation or a gradual one."

"There is no way that India will be insulated if the China currency devalues," said Madhavi Arora, lead economist at Emkay.

"For instance, India already faces a steep trade deficit with China, and it wants to correct. Secondly, all of Asia is heavily intertwined with China. For instance, if China devalues, even economies like South Korea, dependent on China, might face equal pressure given their export baskets," Arora said.

This goes for the others too, she said. "This will spill over to rest of Asia."

While just about 4% of India's exports are to China, emerging Asian economies collectively form a far larger component.

India's exports will take a hit, Arora said.

The rupee is likely to be somewhere in the middle of the EM pack, Arora said. She currently expects the currency to trade below Rs 85 against the dollar this year.

While the Chinese economy is not out of the woods yet, local stock markets have been on a rebound, making the case for a Chinese devaluation less compelling than in 2015.

Anindya Banerjee, head of research for FX and interest rates at Kotak Securities, said the Chinese government has taken a slew of measures to promote equity markets. "If you want to attract foreign flows, the last thing you want is weaker currency," Banerjee said. As such, the Chinese might not want to follow the yen.

What could instead determine the rupee's fate is the risk of no rate cuts by the US Federal Reserve. The sharp change in rate cut expectations has seen US bond yields harden, pressuring the Japanese yen. The world's third-largest economy has one of the lowest bond yields.

However, the rupee also has tailwinds, the biggest of which is inflows following India's inclusion in global bond indices, he said. Foreign portfolio investor flows are expected to return after the completion of the general elections. This will be accompanied with the RBI's intervention to limit sharp appreciation in the Indian currency.

However, while there is no blowout risk right away, if the Chinese authorities decide to devalue, it will be well before the US elections, given the chances of Donald Trump's re-election, he said.