“Can only be solved by rebalancing its economy”

A piece by Patrick Chovenac argues that China should not devalue its currency, “Buffeted by a slowing economy, a falling stock market, and a rising tide of money leaving the country, China is flirting with weakening its currency, the renminbi (RMB). Despite repeated — and very high-level — pledges to maintain its value, Beijing quietly let the RMB slip 5 percent against the U.S. dollar in 2015. Many see its decision in December to switch the RMB’s peg from the dollar to a basket of currencies as a back-door way to piggyback on the weakening of other currencies against the dollar. Meanwhile, a growing chorus of economists, hedge funds, and policymakers are saying that China must “go with the market” and let its currency fall to save its stumbling economy”.

The writer argues that those calling for a Chinese devaluation are wrong, “A weaker RMB won’t fix the problems with China’s economy that are causing capital to flee; it will only make them a lot worse. Only reform and rebalancing — moving away from a reliance on exports and investment to drive growth and toward a more balanced, consumption-based economy — can put China’s economy back on track. Beijing drawing down on its bloated foreign currency reserves to defend the RMB — instead of letting it slide — is integral to making that rebalancing happen”.

However there are serious questions to be asked as to whether the CCP has any real desire, or indeed motivation, for such a move. It would require not just economic but political effort to scale back or even pritatise large chunks of Chinese state owned industry with all its connections to the CCP. That might be a bridge too far for the CCP.

He goes on to argue “Economists are prescribing the wrong solution for China because they are used to dealing with an entirely different set of problems. Countries that suffer a “currency crisis” — unrelenting pressure for their currency to fall in value — are usually debtors that run a trade deficit. If their exports falter, or import prices spike, or foreign financing to cover their trade gap dries up, they will run short of the foreign currency they need to pay their bills. The amount of local currency it costs to acquire (the now scarce) foreign currency will rise, making imports more expensive and locally made goods more competitive, at home and abroad. The shift in the exchange rate sends a corrective signal throughout the economy — consume less, save and produce more — that pushes payments back into balance”.

Logically he adds “China is different. Like Japan in the 1980s, China has piled up a precariously high level of internal debt, but in relation to the rest of the world, it is a creditor nation with a trade surplus. Its problem is not a reliance on external financing to support consumption, but an excessive reliance on external demand to support domestic output and return on investment. The corrective is a stronger, not a weaker, currency that enhances the purchasing power of domestic consumers while discouraging the build-out of even more overcapacity. The question is not whether China is facing an economic crisis, but what kind of crisis. Crises faced by creditor nations have different origins, impose different constraints, and have fundamentally different solutions than those of debtor countries. When Japan suffered a sharp slowdown in growth starting in 1990, accompanied by a property and stock market collapse, it did not face a currency crisis; in fact, the yen actually rose in value”.

He goes on to mention that “Yet the RMB has come under strong downward pressure in recent months. The current pressure isn’t a signal to rebalance — that came in the form of a 36 percent rise in the RMB with relation to the dollar since 2005 — but the result of Beijing’s consistent failure to heed that signal, by flooding the Chinese economy with cheap credit, erecting subtle trade barriers, and propping up money-losing industries. Now, falling asset prices and investment returns, along with doubts about the coherence of Beijing’s policy response, are causing capital to leave the country. Despite a record trade surplus, China is hemorrhaging cash — with an estimated $1 trillion in capital outflows in 2015″.

He goes on to make the point that “Responding by letting the RMB weaken further would be counterproductive on multiple levels. Far from reducing capital outflows, expectations of a falling RMB would only intensify them, pushing the currency down even farther. If expectations were the main problem, then a sudden, large devaluation might preempt and defuse them. But neither gradual depreciation nor a sudden devaluation would solve the major reason money is leaving China: Beijing’s failure to rebalance its economy. In fact, a weaker currency, by subverting the purchasing power of China’s consumers and fostering unsustainable forms of growth — in other words, favouring savers and production at the expense of consumer purchasing power — would only worsen the problem. Even the benefits of a weaker RMB would likely prove illusory. Other countries would quickly come under pressure to devalue their own currencies, erasing whatever advantage Beijing sought to gain. In 2015, a stronger U.S. dollar — against the euro, yen, and a host of emerging-market currencies — cut noticeably into U.S. growth and corporate earnings. Another round of competitive devaluation, triggered by China, could tip the United States into recession. Weakening the RMB would do little to boost China’s exports, if it sinks one of China’s top markets”.

He argues that “The alternative — which China has been doing, at least for the most part — is to support the RMB by drawing on the country’s huge stockpile of foreign currency reserves. Over the past two decades, China’s central bank accumulated nearly $4 trillion by intervening to keep the RMB from rising. Since June 2014, it has sold $663 billion of that defending the exchange rate”.

He ends the piece “What China is facing with these capital outflows isn’t a payments crisis but a crisis of confidence, one that can only be solved by rebalancing its economy. Supporting the RMB sends the right price signals to facilitate that move while buying time for more substantive reforms to unlock a less lopsided path to growth. Of course, it is possible that Beijing will squander this opportunity. Or that it is already too late, that nothing at this point will restore confidence, and all the money will simply flee. But while China may risk failure defending the RMB, not doing so virtually guarantees failure. If Beijing lacked the resources to hold the line, the IMF and other central banks possibly could augment its firepower — and ward off speculative pressure — by lending China hard currency or swapping it for RMB. Buying time for China to rebalance might well be to their advantage, compared to the potentially disastrous global consequences of competitive devaluation”.


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