The first rule of China is that the Party only cares about economic growth. The second rule of China is that the Party only cares about economic growth. And the third rule of China is that the Party will devalue its currency to try to prop up, yes, economic growth.
That last one was full display on Tuesday when China announced that its currency, the yuan, would trade 1.9 percent lower against the dollar, and, if need be, even lower than that in the future. The future got here pretty fast, though, when it fell another 1 percent on Wednesday to bring the yuan to a 3-year low against the dollar. And it had actually fallen as much as 2 percent before China's central bank instructed its state-owned banks to push it up in the final minutes of trading. Even though these moves have been relatively modest so far, the first one was still the yuan's biggest drop in 20 years. There will be more to come.
That's because, as strange as it sounds, the yuan is probably overvalued today. China had been manipulating it down for decades, despite the fact that it let the yuan rise in a restricted manner starting in 2005, but that's over now. China's slowing economy has scared as much as $800 billion out of the country the past year, which, in turn, has made the yuan "want" to weaken. It hasn't, though, because the government has been spending some of its $4 trillion in reserves to keep it from falling.
Well, at least until now. The government says this is a "one-time" devaluation, but it's putting a more market-based system in place that, as Wednesday's trading shows, will let the yuan slide even more. Before now, you see, the yuan was only allowed to trade 2 percent up or 2 percent down each day around a midpoint that the government picked. The new framework will keep these old trading limits, but instead of the government deciding the midpoint, the market will—it will be based more on where it closed the day before rather than on the government's decree. It's an overdue move that, just last week, the International Monetary Fund called on China to make if it wants the yuan to become a reserve currency like the dollar, euro, pound, and yen. And that's certainly part of the reason it did so now.
But, in all likelihood, that's just a sideshow. Sure, China wants it currency and its markets to break into the big boys club, but not if that comes at the expense of growth, which it equates with social stability. Just look at how Beijing reacted when the country's stock bubble burst last month. It didn't sit back and let the market run its course. It suspended the majority of shares, forced companies to buy their own, threatened to throw people into jail for selling theirs, and printed money to purchase even more with. In all, Goldman Sachs estimates that China spent $144 billion bailing out what might have been the most obvious bubble ever. Did Beijing care that these kind of ham-handed interventions would undermine whatever confidence foreigners might have had in their markets? No. All it cared about was getting stocks to stop their vertical descent. In other words, China's commitment to market-based reform is only as strong as its growth. It's convenient when the two are aligned, like they are with the yuan, but if they're not, the Party will choose short-term growth every time.
And right now, China could use some more growth. How is that possible when its economy is still expanding at a 7 percent clip? Well, that's the slowest China has grown in 20 years, if it's even growing that fast, and the Party is pathologically afraid of slowing down any more. The problem is that China's housing bubble has plateaued, its stock bubble has popped, and its exports have gotten pinched by the strong dollar translating into a strong yuan. As you can see below, the yuan's soft peg to the dollar has meant it's gone up 9.2 percent against the euro and 57.8 percent against the yen the last three years, with most of that happening the last 12 months as the Federal Reserve has gotten ready to start raising interest rates. Indeed, China's real trade-weighted exchange rate has shot up 14 percent the last year alone.
That's made life pretty hard for China's exporters, enough that overseas sales slumped 8.3 percent in July from the year before. Now, China can, and apparently will, try to devalue its way back to competitiveness, but it doesn't want to do too much of that. Chinese companies have taken out a trillion dollars of debt—emphasis on dollars—that would be harder to pay back if the yuan fell too far. And too big a devaluation could mean even more capital flight, which could then turn into an even bigger devaluation. It would overshoot. So Beijing would prefer a managed decline. It wants the yuan to fall enough to help exporters, but not so much that it hurts the rest of the economy. Something, according to the latest rumors, like a 10 percent drop. And that's why it intervened on Wednesday to keep the yuan from falling too far too fast. China wants a weaker yuan, but on its terms.
So much for making the yuan more market-based. And for the idea that China is liberalizing the yuan so it can become a reserve currency. Beijing is only interested in liberalizing the yuan so long as it serves its own economic interests. Right now, that means a cheap, but not too cheap, currency. If the yuan falls further than that, though, the government will set aside its market shibboleths and do whatever it takes to get the price where it wants it.
Beijing's only principle is power, and its only legitimacy for that power is economic growth. That's the implicit social contract it's struck with its people: you'll get rich, but you won't get rights. If the government thinks it needs a weaker currency to hold up its end of the bargain, then the country will have a weaker currency. And it sure seems to think that now. China's consumers don't have enough money to power the economy, China's builders have borrowed too much money to do so anymore, and China's exporters can't make much money when the yuan is so expensive. Of these problems, the last one is the easiest to solve, so that's what Beijing has done. Even then, though, it's done it in a way that, as Paul Krugman points out, is all-but-guaranteed to create more capital outflows, and put more pressure on the yuan to weaken. Instead of devaluing all at once, China has taken a gradual approach that will give people every reason to move more money out of the country before it's worth any less.
China's currency devaluation is only beginning.