In recent days, China has surprised markets by significantly lowering the value of their currency relative to the dollar. Equally surprising, this has been front page news. Some of that’s probably because August has been a slow news month. Let’s talk about what going on with China and why it’s getting so much attention.
What is a currency devaluation?
It’s when the value of one country’s currency falls relative to that of another. In this case, the value of the Chinese yuan is down more than 4 percent over the last few days, which is a lot — much more than the yuan’s usual daily ups and downs.
Why did it fall so much?
Because the Chinese government — really the People’s Bank of China (PBoC), which, unlike our own central bank, is not independent of the government — let it. They set the value of the yuan relative to the dollar every day, and then let it fluctuate daily within a narrow range before setting it again the next day. Market forces were pushing the yuan lower than that narrow range would allow, so the PBoC let if fall.
Why would they do that?
At least two reasons. First, those market forces I mentioned are pushing against the value of yuan because China’s growth rate has slowed considerably over the past few years. In addition, the Chinese stock market recently underwent a large correction, and most relevant to this discussion, net exports, typically a major source of growth for the Chinese economy, have fallen off sharply.
That introduces reason #2: by letting their currency lose value, China’s exports become cheaper while imports from others become more expensive to Chinese consumers. All else equal, when a country buys less from others and sells more to them, it grows faster.
This is a critical point in this corner of international economics. While a currency devaluation sounds bad, and, as noted, often reflects economic problems, in terms of international competitiveness, it’s actually helpful. In fact, it’s an essential market mechanism for correcting internal negatives by boosting net exports. Economists sometimes call this a “competitive devaluation” because it makes the devalued countries’ exports more price competitive in foreign markets.
(Note: this corrective mechanism has been unavailable to struggling euro zone countries like Greece that, by dint of membership in the currency union, no longer have their own currency.)
Why is China’s currency devaluation front page news?
So, armed with that last bit of information, we’re ready to tackle this one, though as I intimated, I’m not exactly sure. It’s widely known the Chinese economic authorities manage the value of their currency through the “daily fix” process noted above, so that’s not news. But interestingly, I think the answer here may relate to the big debate we were having a few months back over the Trans Pacific Partnership trade agreement.
During that debate, there was a lot of arguing about whether the agreement should do more to prevent the type of currency management (some call it “manipulation”) that China — and they’re not the only ones — has long engaged in. Even though China’s not one of the countries in the TPP deal, those who believe such currency interventions tilt the playing field against our manufacturers and contribute to our trade deficits (and I’m one who makes that case) suggested that the TPP would be a good place to introduce enforceable rules against currency management.
We lost that argument, but in the midst of it, TPP proponents, including the White House, argued that China’s currency was no longer misaligned (undervalued relative to the dollar) which was true, and thus we could worry less about competitive devaluations there and elsewhere.
We now see that this last bit — about China not devaluing — looks to have been a bad call. And given the tensions around the TPP, a treaty which is still far from ratified, that may well be the stuff of headlines.
But hold up. You said the devaluation was market driven. How could that then be “manipulation” which sounds policy, not market, driven?
That’s what makes this incident so interesting. China controls/manages the value of the yuan — that’s not in question. And in doing so, they just let it fall sharply. That’s a devaluation, managed by the monetary authorities. The fact that the market was already pushing in that direction doesn’t alter that fact.
At the same time, the Chinese authorities have said that they’re going to set the daily rate based on the market value of the yuan to the dollar going forward, not on their own preferences. If so, it will constitute a softening of the type of currency management they’ve long practiced.
The test of this will be when the market pushes the value of yuan up, making Chinese exports less competitive. At that point, we’ll get a chance to see if this new found market allegiance is symmetric.
One more thing: Opponents of a currency chapter in the deal made the point that even if they wanted to, they couldn’t write these rules without implicating central banks, like our own Federal Reserve. They argued that when the Federal Reserve lowers interest rates it feeds into a weaker dollar, and there’s no way to distinguish that from currency management.
A number of us argued that was bunk, based on the point that while exchange rate movements are a side effect of central bank macro-management, they’re the main event in currency interventions that directly target the exchange rate.
In fact, the People’s Bank of China lowered interest rates to spur growth four times in recent months, and I saw no headlines of the type I’ve been seeing in recent days. Yet, when they devalued, the headlines appeared. Either the TPP advocates were wrong or our headline writers are brilliant economists who somehow managed to suss out this allegedly arcane difference.
The next big question is how far the yuan will fall and will the People’s Bank of China hit the brakes if they view it as undervalued? Or will it stabilize soon?
Will it lead to knock-on devaluations by those who compete with China for export markets? Will any of this stay on the front page post-August?