China Depreciation: Trouble for the Global Economy?

The shock waves created by China’s small devaluation of its currency were unsurprising given the long-held belief that Beijing would keep the renminbi stable in preparation for being included in the IMF’s nominal currency, the SDR. But it is now one more uncertainty hanging over the global economy.

Only the IMF itself and the US Treasury seemed to treat the devaluation as showing greater flexibility of the exchange rate, as China insists, and increased responsiveness to market forces. This was not, China assured the world, the start of a round of competitive devaluations.

Yet most markets didn’t see it that way for some very good reasons. The decrease followed a sharp fall in China’s exports and the continuing declines in most Asian [and other] currencies against the US dollar which have undermined China’s competitive position in some industries. A weaker currency also seems to fit with the government’s increasingly frantic needs to stimulate a weak economy – and prop up the stock market.

The governor of the People’s Bank of China, the central bank, is undoubtedly sincere in his desire to see greater exchange rate flexibility and some shift towards market-determined rates. However, there are too many other forces at work to make that easy.

And anyway what is the definition of a market-determined rate? In China’s case it is impossible to imagine a situation in the foreseeable future when the PBOC itself is not the determining factor. The reason is simple. One important measure of whether a currency is correctly valued is its medium-term current account position.

China’s current account remains in massive surplus because weak exports have been matched by weak imports as key commodity prices – oil, iron ore, coal, soybeans – have collapsed.

China is one of the very few developing countries with a current account surplus. It has also been reducing reliance on imported components. The fundamental case for a weaker currency is feeble, at least until commodities rebound, which looks unlikely over the next 12 months.

Yet market forces today, especially for those with few capital controls, are driven by capital movements, not current accounts. China is suffering a large capital outflow and will continue to do so now that its currency is more likely to go down than up. A weak domestic economy ensures that interest rates will stay low while those in the US at least may rise.

Given its overstocked exchange reserves, China has no reason to worry about this outflow. But it does mean that PBOC intervention must be more than the occasional smoothing of daily fluctuations. The extent to which the PBOC sells dollars into the market will be the main determinant of yuan value. Can the PBOC ward off calls for further depreciation?

Which brings us back to the balance of forces within China. Some, like the Ministry of Commerce, want a weaker currency and others ranging from the PBOC to dollar-indebted mainland property companies which want near stability against the US dollar.

Where President Xi stands is unclear but he may become desperate to try anything to stimulate the economy

For sure any devaluation of less of double digits is meaningless in terms of trade competitiveness. A worry even for those who want a weaker yuan is that it will simply spark further weakness in currencies ranging from the Korean won to the Indonesian rupiah. Indeed almost every developing Asian currency fell faster than the yuan last week.

China has a particular problem in that it faces two sets of competition. One is at the high end where it is trying to catch up with Korea, Taiwan and Japan, while at the other it is trying to stay ahead of lower-income Vietnam, Indonesia etc. The two situations of developed and developing Asia are very different even though the currencies have been performing similarly.

The won has been happy to fall and allow Korean chaebol to regain a little competitiveness against Abe’s deliberately weakened yen. Ditto Taiwan’s New Taiwan dollar. Both Korea and Taiwan have also been hurt by China’s slowing demand and thus seen capital outflows. But the main reason for the weakness of the ringgit, rupiah etc has been the collapse of commodity prices. The Australian dollar has suffered as least as much. Supply excess more than weak Chinese demand has been the main cause of the commodity bust.

But currencies weakened by commodity prices also offer those countries opportunities to gain manufactured exports at China’s expense. China at the macro level may not need such low-value business, but many millions of workers still depend on it. The greater the difficulty Beijing has in spurring growth from new industries, the more clout these old ones will have.

For sure Beijing does not want to get embroiled in another conflict with the US over exchange rates, particularly given the abysmal levels of understanding of the issue displayed by the aspirants to succeed President Obama. Nor does it want to aggravate relations with Southeast Asian neighbors agitated by its empire-building in the South China Sea. But predicting the value of the yuan against the dollar 12 months hence is now no easier than predicting the dollar against the euro, won, or Mexican peso.