China's de­val­u­a­tion can't be good news

The Pak Banker - - OPINION - Noah Smith

As you've no doubt heard, China has de­val­ued its cur­rency. The ex­change rate be­tween the yuan (also known as ren­minbi, or RMB) and the dol­lar is al­ways con­trolled by the Chi­nese gov­ern­ment, which sets a value and al­lows the rate to trade in a nar­row band around that value. On Tues­day China moved its tar­get by about 2 per­cent, then fol­lowed up with a sec­ond de­val­u­a­tion the next day. The big ques­tion is: "Why is this hap­pen­ing?" There are three ma­jor the­o­ries. The first is that China is re­spond­ing to an eco­nomic slow­down by de­pre­ci­at­ing its cur­rency in or­der to stim­u­late ex­ports. The sec­ond is that China is re­spond­ing to mar­ket pres­sures, which are push­ing the yuan lower due to the afore­men­tioned down­turn. The third is that China's gov­ern­ment is sim­ply pre­par­ing the coun­try's cur­rency for in­ter­na­tion­al­iza­tion, in ac­cor­dance with the rec­om­men­da­tions of the In­ter­na­tional Mon­e­tary Fund.

Let's start with the third the­ory, which -I'm sorry to say -- makes no sense at all. Ni­cholas Lardy of the Peter­son In­sti­tute for In­ter­na­tional Eco­nom­ics makes the IMF ar­gu­ment in a re­cent blog post:

[China's] mo­ti­va­tion for this move is al­most cer­tainly tied to another ob­jec­tive: China's as­pi­ra­tion to have the RMB join the four other ma­jor in­ter­na­tional cur­ren­cies (the dol­lar, the euro, the pound ster­ling, and the yen) that com­prise the so-called spe­cial draw- ing rights (SDR) bas­ket of the In­ter­na­tional Mon­e­tary Fund (IMF). The IMF ex­ec­u­tive board will de­cide in Novem­ber whether to in­clude the RMB in that bas­ket. The ac­tion taken by China, far from be­ing a step to ma­nip­u­late its cur­rency, is ac­tu­ally an ef­fort to let the RMB fluc­tu­ate ac­cord­ing to the dy­nam­ics of the ex­change mar­kets...China's move is con­sis­tent with long-stand­ing ad­vice from the IMF and from the US Trea­sury, both of which have re­peat­edly called for China to adopt a more mar­ket-de­ter­mined ex­change rate pol­icy.

This surely isn't the main rea­son be­hind China's move. First of all, the tim­ing is sus­pect. China is un­der­go­ing what seems to be a sharp eco­nomic slow­down. It re­cently suf­fered a col­lapse in stock prices, which is of­ten (though not al­ways) a harbinger of re­ces­sion. That stock mar­ket crash came on the heels of a fall in the far more im­por­tant real es­tate mar­ket. All in all, China looks like it is go­ing through ex­actly the same bub­ble-and-bust dy­namic that is all too fa­mil­iar to ad­vanced economies.

That the Chi­nese gov­ern­ment would choose ex­actly this mo­ment to lib­er­al­ize its cur­rency is just too con­in­ci­den­tal to be be­lieved. There are other rea­sons to doubt the "in­ter­na­tion­al­iza­tion" story. For one thing, the move sparked up­heaval in fi­nan­cial mar­kets around the world. If ev­ery­one had known that China was go­ing to do some­thing like this in prepa­ra­tion for the IMF's Novem­ber de­ci­sion, those mar­kets prob­a­bly would have priced in the de­val­u­a­tion ahead of time. Also, the gov­ern­ment's ac­tion isn't re­ally con­sis­tent with a per­ma­nent mar­ket-ori­ented cur­rency lib­er­al­iza­tion -- if it were re­ally pre­par­ing to float the yuan, it seems like it would have dra­mat­i­cally widened the band in which the cur­rency is al­lowed to trade, rather than sim­ply re­set­ting the tar­get value by fiat. To me, the "in­ter­na­tion­al­iza­tion" ex­pla­na­tion seems to fit with a gen­eral ten­dency of com­men­ta­tors -- both Western and Chi­nese -- to por­tray the Chi­nese gov­ern­ment as all-know­ing, wise and in firm con­trol of the econ­omy. As my Bloomberg View col­league Justin Fox re­cently wrote, this prob­a­bly isn't the case.

In­stead, we should think of China's de­val­u­a­tion as a re­sponse to its de­te­ri­o­rat­ing eco­nomic sit­u­a­tion. That still leaves the ques­tion of whether the re­sponse is an ac­ces­sion to mar­ket pres­sures, or just an at­tempt to stim­u­late ex­ports. The real ques­tion is whether the yuan is over­val­ued or un­der­val­ued.

If the yuan is over­val­ued, then mar­kets want to sell it, and the gov­ern­ment is merely giv­ing them the op­por­tu­nity to do so, in or­der to avoid a more dra­matic down­ward reval­u­a­tion later on. That would seem to fit with sto­ries of in­creased cap­i­tal flight from China. If peo­ple re­ally do think the yuan is over­val­ued and the econ­omy is about to slow dra­mat­i­cally, it would be a rea­son to pull money out of the coun­try (though do­ing so is dif­fi­cult be­cause of cap­i­tal con­trols).

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