China’s devaluation of yuan can’t be good news

CHINA has devalued its currency. The exchange rate between the yuan 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.

There are three major theories as to why this is happening. The first is that China is responding to an economic slowdown by depreciating its currency to stimulate exports. The second is that China is responding to market pressures, which are pushing the yuan lower due to the downturn. The third is that Beijing is preparing the yuan for internationalisation, in accordance with recommendations from the International Monetary Fund (IMF).

Reasons

Let’s start with the third theory, which makes no sense at all. Nicholas Lardy of the Peterson Institute for International Economics made 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 yuan join the four other major international currencies (the dollar, the euro, the pound sterling and the yen) that comprise the so-called special drawing rights basket of the IMF. The IMF executive board will decide in November whether to include the yuan in that basket.

“The action taken by China, far from being a step to manipulate its currency, is actually an effort to let the yuan fluctuate according to the dynamics of the exchange markets… China’s move is consistent with long-standing advice from the IMF and the US Treasury, both of which have repeatedly called for China to adopt a more market-determined exchange rate policy.”

This surely is not the main reason behind China’s move. First, the timing is suspect. China is in a sharp economic slowdown. It recently suffered a collapse in stock prices, which is often a harbinger of recession. That stock market crash came on the heels of a fall in the far more important property market.

That China’s government would choose this moment to liberalise its currency is just too coincidental to be believed. Also, Beijing’s action isn’t really consistent with a permanent market-oriented currency liberalisation – if it were really preparing to float the yuan, it would have widened the band in which the yuan trades, rather than resetting the target value by fiat.

To me, the “internationalisation” explanation seems to fit with a tendency of commentators to portray Beijing as allknowing, wise and in firm control of the economy. This probably isn’t the case.

Instead, we should think of China’s devaluation as a response to its deteriorating economic situation.

For more than a decade, the conventional wisdom has been that China keeps its currency pegged artificially low to stimulate exports. If that is the case, then China’s devaluation is simply more of the same – an attempt to ward off recession by making the yuan even more undervalued.

Either way, the devaluation isn’t a good sign for the Chinese economy. Peking University professor Christopher Balding explained why in a recent blog post. He argued the devaluation would probably make markets expect further devaluation, which would tend to accelerate capital flight, especially if the Federal Reserve hikes interest rates, as it is expected to do. Devaluation will also hurt Chinese firms that have borrowed dollars, since it will now be harder for them to pay back loans.

So whatever the real reason for China’s devaluation, it’s bad news and a bad signal for the Chinese economy.