Chinese President Xi Jinping has just added a chainsaw to what had already been a pretty daunting juggling act. All year he's been trying to keep aloft two giant economic bubbles -- one in debt, one in stocks. This week he added a much more unwieldy prop, the value of the yuan, to the show.
As I've argued, China is entirely justified in lowering its exchange rate, so far by 2.8 percent. It's a risky move, but worth taking if it stabilizes the world's second-biggest economy and nudges it toward a market-determined financial system -- assuming Xi's team truly knows what it's doing.
The problem for China's president is this latest challenge threatens his ability to manage the other two. As China guides its currency lower, it heightens default risks on foreign-currency debt and increases the odds of capital flight, which would slam stock prices.
It's not that China lacks latitude to devalue its currency. Before Tuesday's 1.9 percent cut in the central bank's reference rate, the yuan had risen about 15 percent on a trade-weighted basis in 12 months. But there are other considerations that should constrain Chinese policy. The Group of Seven nations would throw a fit if China lowered the yuan's value any further; China could even become a target for candidates in the 2016 U.S. presidential election.
That's why Wednesday's devaluation by an additional 0.9 percent raised more questions than it answers. The whole idea of devaluing is to do it all at once: make a huge, one-time step, ride out the turbulence and move on. China, it appears, favors a drip-by-drip approach.
That could dent the market's confidence in the country's policy makers. Will investors, analysts, risk managers, executives and journalists feel they can still rely on Chinese pronouncements, or will they have to sit on pins and needles every morning, waiting to see how much the People's Bank of China lops off the yuan?
As Ray Dalio of hedge-fund manager Bridgewater Associates sees it, Beijing's "promises to defend it here will need to be kept or it will lead to a loss of credibility -- like the implied promise to support the stock market at around 3,500 needs to be defended or it will lead to the appearance that the marketplace is more powerful than the government." Failure to hold the line, Dalio says, "will add currency volatility to stock market volatility and economic volatility on the government's list of worries."
It's not clear whether Xi's team understands the trap it's setting for itself. Beijing is already stuck on what hedge-fund manager James Chanos calls a "treadmill to hell" as local governments amass $4 trillion of debt and credit. The Chinese government has also ensnared itself in a dangerous cycle of stock-market interventions that imperil its global clout. Wednesday's bloodbath in shares of major e-retailer Alibaba demonstrates the worsening state of economic fundamentals.
Xi is now willfully creating a currency contrivance that complicates his ability to avoid a hard landing for the national economy. The why of Xi's devaluation is clear enough. So is the what, as officials from Washington to Tokyo voice concerns about a new currency war. The problem is the how; that's where Xi's people may be courting a self-inflicted wound.
Given China's tightly-controlled financial system, it doesn't have to fear a major speculative attack by currency traders. Still, there's reason to wonder whether the country's central bank is up to the challenge Xi is presenting it. Smart and respected as he is, Governor Zhou Xiaochuan may have to go on a hiring tear for money-market experts who can help manage the government's new policy. Beijing has already shown its inability to adequately manage the country's stock prices and its levels of debt. Currency markets may likewise demonstrate Beijing's impotence.
China could end the drama by stating clearly that the yuan's big declines are over for now. That would calm nerves in markets and head off a brewing geopolitical storm of protest and copycat devaluations. The PBOC may have done just that Wednesday, intervening to prevent the yuan from going too far.
Amid these discussions, Washington finds itself caught in an ironic position. For years, the U.S. criticized China for not letting markets decide the yuan's value, on the assumption that it was undervalued. Now that traders have a bigger say, the yuan is moving down -- a direction that probably doesn't please Treasury Secretary Jacob Lew.
Nonetheless, there comes a point where China will need to take economic realpolitik into account. The benefits from a weaker yuan will fade quickly if the world fears Beijing is acting rashly, or further huge drops are coming. And if Xi fails at managing the course of China's currency, his entire juggling act will come to an untimely end.
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