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China's Devaluation Can't Be Good News

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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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.

China's Managed Markets

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 drawing 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). 

But few are willing to claim that the yuan is overvalued. For more than a decade, the conventional wisdom has been that China keeps its currency pegged artificially low in order to stimulate exports -- a policy generally known as mercantilism. If that is the case, then China's devaluation is simply more of the same -- an attempt to ward off recession by making the currency even more undervalued. 

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

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

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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