Follow Up to Bloomberg on Chinese Devaluation

As usual, I want to provide a little follow up to my BloombergView piece on why devaluing the RMB won’t solve Chinese economic problems.

  1. I am not saying that the PBOC and Beijing should defend at all costs the RMB if there is a large sustained outflow of capital. A lower RMB may very well be in the future of China.  The futures market certainly thinks so and based upon the creeping capital controls, it is likely Beijing sees the same events unfolding.
  2. I am saying that it is an enormous mistake to think that a lower RMB will kick start the Chinese economy and restore peace and justice to the universe to grow at 10% annually again. Simply won’t happen.
  3. This is most empirical reasoning much of which I outline in the piece. For instance, though a large trading country in absolute terms, it represents less than a quarter of the entire economy.  Consequently, even if it grew fast, it would represent a small fraction of the overall economy.
  4. Given the large amount of processing trade and reliance on imports to build other exports, a not insignificant amount of the gain to export volume would be eaten up by more expensive imports. Exports might become cheaper, but that means imports are more expensive.  When you need both to trade, you’re not gaining nearly as much as you think.
  5. Given the products China exports, still very reliant on low value products, China needs to compare itself to Indonesia, Vietnam, Thailand and Brazil not its basket of currencies. The basket is comprised primarily of USD, Yen, Euro, etc.  Ask yourself this, though how many Mercedes (or high value cars) does China export? Not many.  The Chinese export basket is still dominated by low value products like garments and electronics assembly.  Changing yes but still dominated by those products.  Consequently, demand for those products is rising but definitely slowly.  This has two enormously important implications.  First, Chinese exports can only increase rapidly by taking market share from other EMs.  This has been happening in recent years but simply not fast enough to push trade.  When global trade was rising rapidly China was a significant beneficiary.  Now with global trade growing slowly, China can only rely on exports by taking market share in large amounts from other EMs.  Second, which flows directly from the first point, is that to drive exports, the RMB would not need to fall against its basket of USD, Yen, EUR, but rather relative to a basket of EM currencies.  That means that to regain competitiveness against its largely EM competitors, it would need a very large devaluation.  Let me give you a simple example.  Let’s assume that all currencies were at an index value of 100, EMs and China in this case.  Over the past year let’s assume that the other EMs have drifted downwards so they are now at 80 (indicating weakening) while China remains at 100 compared to its basket of mostly DM currencies.  For China to regain cost competitiveness against other EMs, it would need to drop to say 70 or 60 before there was a significant benefit. (I want to emphasize, these are just simple numbers to illustrate the point, not intended as a currency forecast).  As other people like Paul Krugman and Bloomberg’s Tom Orlik have pointed out, a mildly weaker RMB will simply have no impact on trade.  Tom Orlik has estimated that the RMB would need to fall to at least 7.7 TMB/$ before there was an appreciable impact on trade.
  6. Given the level of debt, as foreign debt represents a very small percentage of the overall whole, the deflationary spiral is very difficult position for China. Without stimulating some type of inflation, the debt deflation spiral China finds itself will be very difficult to solve.
  7. The problem is that loosening monetary policy only pushes money out of China. The PBOC has recognized this problem and rather than lowering interest rates or RRR, they are trying to push liquidity via reverse repo injections.  I see that as another band-aid over a gunshot that likely solve a short term problem but nothing to solve the real problem.  The more it loosens, the more pressure it places on the RMB.
  8. As I wrote in a previous BloombergViews piece, though it goes entirely against monetary orthodoxy, I would argue that if China wants to stimulate inflation, it should raise interest rates and be prepared to deal with a not insignificant number of firms.
  9. The overall problem is that China is no longer left with good and bad options, but an array of bad options. The policy options are dwindling.  Everything they are doing is really just placing a band aid over a gunshot wound.  The latest is to limit MNCs taking money out of China.   That’s not exactly the way to encourage more investment.
  10. Capital outflows are a Chinese phenomenon, not a foreigner or hedge fund problem.

7 thoughts on “Follow Up to Bloomberg on Chinese Devaluation

  1. Great post Professor! I especially appreciated points 6-10!

    The general feeling you give is of very reactive policymaking squirming between bad options and putting off the really tough options that are going to start the very slow and painful process which will eventually lead to a better situation!

  2. Hi, I am familiar with you because of your Sizing Up The NPL Risk article.

    While perhaps not aware of its extensiveness, Ben Bernanke has recently gone on record saying that China’s debt is an “Internal” issue. Thus it is making sense that inflation could help; or be viewed as a remedy. Your point 8. above addresses the topic, but pertaining to a country that is known for paying close attention to currency, would a big devaluation:
    1) Help to preserve the stock pile of reserves consistent with the IMF’s recommendation?
    2) Perhaps be believed to aid the NPL issue, when it needs to be reckoned with, by policymakers? Rogoff’s recent analysis must be getting back to them.

    • I just posted a big follow up on the issues you ask about. Bernanke is right that the NPL is almost exclusively an internal issue. If they floated, they would really have very little need for reserves and a devaluation would likely accompany them floating. I think a big devaluation without a float would only create more pressure. I don’t see how devaluation helps the NPL issue very much. Dmaybe through increased demand for Chinese exports? Not enough to save all those firms. Some for sure but not a major difference. Because the debt is largely internal, devaluation will only impact the NPL through trade and production and trade simply won’t increase enough even with large devaluation. I don’t think there is a strong direct link.

  3. Chris I had a question about the method that the Chinese government has chosen to push liquidity into the system. As you stated above, the Chinese have avoided using RRR or interest rate reductions, and instead have focused on OMO via reverse repo injections. Why is this viewed by the financial community as a better option? The Chinese seem to believe this will bring more stability to the Yuan, but you also say that this is a bandaid, and I also agree but I can’t understand why people are viewing the use of reverse repo injections as more positive, so I’m at a loss as to what the Chinese are actually trying to accomplish. Any insight here?

    • Sorry for the delay. Travelling. I honestly don’t see any fundamental difference in how this money will impact the system. Basic idea goes like this: a) money is fungible b) PBOC increases liquidity through either interest rate cut, RRR cut, or open market operations. c) liquidity looks to leave the country. The market (the non-banks) does not, because money is fungible, distinguish between how the liquidity entered and will leave. d) their logic though I believe very weak is this: Reverse repo’s require a redemption so the money won’t flee as easily. From a PBOC to bank perspective this is right, but bank customers are the ones moving the money out of China not banks. Consequently, the additional liquidity continues to be used to leave China. I suspect the PBOC is just trying anything but they have to know this is simply a stop gap.

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