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China’s Devaluation: Much More Trouble to Come?

Walter Russell Mead

The People’s Bank of China appears to have caught itself in a conundrum of its own making: yesterday it announced a 1.9 percent devaluation of the yuan, and pledged to allow market forces to have more influence on the currency’s value going forward (a move warmly welcomed by the IMF). At the same time, Beijing pledged to keep the yuan stable, and at a “reasonable” level. Today, hewing to its new market-based policy, the PBOC set the midpoint for the currency near yesterday’s low market close. During the day, renewed speculation had the yuan trading another 2 percent down, despite PBOC claims to investors that there was “no economic basis” for further depreciation. Finally, in the last 15 minutes of trading, the central bank instructed state-owned banks to sell dollars in order to prop up the yuan, which ended up down less than one percent on the day—a total of 2.8 percent down since the close of trading on Monday.

But just because China wants to modulate the yuan’s descent does not mean it is unhappy with it overall. As we explained yesterday, China is using a moment when market forces are pushing the currency down to do something it wanted to do anyway in order to stimulate exports. And with that we are looking at a major shift in world markets—one with both economic and geopolitical implications.

The fact that leaders in Beijing determined that devaluation is necessary is more evidence that the economic troubles we’ve been seeing in China are more than a blip on the screen. Something serious is happening. Depreciating the currency is a way to re-energize an export-oriented economy that has been running low on growth. China wouldn’t do this if it could avoid it; in the past it took great pride in holding its currency steady as other Asian currencies melted down around it. Avoiding the competitive currency devaluation wars was one of the pillars of China’s claim to being more than just another emerging economy. Yet here China is, diving into the Asian currency wars it has so assiduously avoided.

So now China is exporting deflation. Overproduction of key materials and goods in China—the Great Bubble of excess manufacturing capacity that powered much of China’s massive growth but is now a greater and greater burden—is forcing Beijing to reduce the price of its exports so that companies can sell more of their excess production at lower prices abroad.

This is going to hit two important economic sectors and the countries who depend on them: there will be additional deflationary pressure on commodities worldwide, and there will also be deflation in the cost of manufactured goods. When China’s currency loses value against the dollar, everything at Walmart gets a little cheaper. That’s good for consumer standards of living, but bad for the firms competing to sell stuff that China makes. The world’s metal producers, Bloomberg reports, are already taking a hit.

This increases the pressure on many countries to devalue their own currencies to stay competitive with China. That’s going to be trouble. Many companies in those countries have borrowed in foreign currencies and if their own currencies depreciate that’s going to make those loans harder to repay.

There will also be an exodus of capital from China and from countries likely to follow it down the path of devaluation. If your home currency is going to lose value in the next six months, you would be smart to move your money into foreign currency assets—stocks, bonds, and real estate in countries like the U.S. where the currency is expected to rise. Back in July, we noted that a quarter of a __trillion __dollars of private capital had already fled China. And that’s a feedback loop which can turn into a vicious cycle at the macroeconomic level; capital outflow can increase the pressure on currencies, forcing them to depreciate further, accelerating the capital flight, leading to more depreciation, etc. This in turn can depress stock markets as both foreign and local investors shun local stocks in depreciating currencies. And more trouble on stock exchanges is the last thing China or its neighbors want.

If the Great Bubble is really starting to deflate, we are going to see a lot more turmoil in world markets—and, as some observers have noted, it’s going to be that much harder for the Fed to tighten interest rates in the fall.

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