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Yuan devaluation: China cannot just export its way out of trouble

Manoj Pant | Updated on: 13 February 2017, 3:43 IST

The devaluation

  • China has brought the yuan down to about 6.43 per dollar, the lowest in four years
  • This is because growth has tremendously slowed down
  • GDP growth was at 7% last month. Exports are falling

The rationale

  • By devaluing the yuan, China is trying to boost exports
  • This is an old strategy for China
  • IMF approves of the move. India\'s chief economic adviser thinks its a masterstroke

The alternative

  • This strategy might not work. Worldwide demand for exports is stagnant
  • China should have done the reverse, by trying to boost domestic consumption

In three successive days of devaluation China brought its currency, the yuan, down to about 6.43 per dollar which is the lowest level it has reached in the last four years or so. Fears of a currency war led the authorities to halt the slide on Friday by a slight upward revaluation.

This has followed a GDP growth of 7% last month which is considerably slower than the double digit growth for a decade before that.

This devaluation has also come at a time when the Chinese stock market has shown signs of crashing. This is important to China as the stock market fall has eroded wealth of a large number of small investors.

Furthermore, Chinese exports have slid by over 8% in the last month which is quite worrisome for a country which has built its wealth on an export oriented platform. Clearly, the Chinese economy is in serious trouble after three decades of glorious growth.

Old game or masterstroke?

Remember that about four years ago China had set in motion a process of revaluation after the USA complained that the yuan was being kept at an artificially low level leading to a build up of enormous trade surpluses.

This "unfair trade practice" was seen as one which could justify US action against China under the Super 301 law. In fact, China's trade surpluses have remained at a high of around $3 trillion mainly on the back of its exports to the USA. So is China going back to its old game?

India's chief economic advisor seems to think that the Chinese devaluation was a "masterstroke". According to media reports the Chinese devaluation is merely a measure to "let the exchange rate float freely" and is a step in making the yuan freely convertible.

Apparently, this is a view also supported by the IMF. So was this simply a "benign" adjustment by China and will things soon go back to normal?

In this article I will argue that this "masterstroke" was China's attempt as before to export its way out of its domestic problems. I will argue that in today's world this strategy will not work and in fact China has avoided what could have been the right strategy to help a troubled world economy.

Why the devaluation might not work

First, note that in recent months China has also seen a deflation in factory gate prices. With deflating prices, one would expect a market driven yuan to appreciate (to maintain its real effective exchange rate) in order to keep China's relative prices the same vis a vis other countries.

Intuitively, as prices in yuan fall within China, so do the dollar prices. This increases demand for Chinese goods and hence for the yuan and, in normal circumstances, the yuan would appreciate (revaluation) vis a vis the dollar. This is fairly elementary introductory economics. This explains why countries like India with high internal inflation and trade deficits tend to see their currencies depreciate.

What does the devaluation do? It promotes external demand for Chinese goods while further restricting Chinese internal demand for imports. The present devaluation to that extent is thus certainly an export promoting move and has already seen a sympathetic devaluation around the globe as countries try to keep their competitive edge vis a vis the yuan.

China should have expanded domestic consumption by running down trade surpluses and buying more from the world

After decades of over-investment China should have been expanding domestic consumption by running down its trade surpluses and buying more from the rest of the world. It has instead chosen to "export its way out of trouble", a strategy that is bound to fail when world export growth is stagnant.

With slow global growth and exporting countries competing for the same shrinking pie, currency wars are inevitable. As history has shown, these "beggar thy neighbor policies" never work. In fact, the Chinese should have been revaluing the yuan, generating greater demand for products of the rest of the world and reducing its huge trade surplus.

This "mercantilist" fascination for huge trade surpluses has long since been discredited. Surprising to see the IMF (and our chief economic advisor) lauding it.

So what can be expected?

It is early days yet but the biggest concern is in the asset markets. As fears of Chinese troubles become real, international investors are likely to liquidate their positions to generate cash balances. So some turbulence in world stock markets can be expected.

Where it stops will depend on how the "currency wars" pan out. In any case, stock markets would react quickest as financial capital can move at the speed of light in these days of high frequency trading.

What are the implications for India? Continued slow export growth is on the cards but some of the investment in the Chinese stock market can be expected to relocate in India as a part of a global rebalancing effort. This would put further pressure on the rupee to revalue which the Central bank will resist thus building up foreign exchange reserves.

Hopefully, the RBI will one day realise that an exchange rate propped up by short term capital flows is bad economics. It will also (hopefully) dawn on the monetary authorities that in India the interest rate is not an anti-inflation measure. But mismanagement of India's foreign and domestic markets by the RBI merits a separate article.

As usual, China has shown that it is not willing to solve its domestic mismanagement by domestic demand promoting measures. Again, as usual, it is exporting its problems to the rest of the world. How it pans out this time only time will tell.

The views expressed here are personal and do not necessarily reflect those of the organisation.

First published: 17 August 2015, 11:08 IST
Manoj Pant @CatchNews

The writer is a professor at Centre for International Trade and Development, School of International Studies, Jawaharlal Nehru University, New Delhi.