China’s forex follies


Prof. Barry Eichengreen explains China’s forex follies:

On August 11, China devalued its currency by 2% and modestly reformed its exchange-rate system. This was no earth-shattering event, but financial markets responded as if a meteorite had struck them. The negative reaction is no mystery: China’s devaluation was a textbook example of how not to conduct exchange-rate policy.

One of the government’s motivations was presumably to give a boost to China’s slowing economy. Although the service sector, which accounts for the majority of employment, is holding up relatively well, the country’s output of tradable goods, many of which are produced for export, is weakening sharply. Chinese exporters are caught between the pincers of weak foreign demand and rapidly rising domestic wages.

Devaluation is the tried and true remedy for such ills. But a 2% change in currency values is too little to make much of a difference, given that wages in Chinese manufacturing are rising at an annual rate of 10%. It could be that Chinese policymakers regard the 2% devaluation as a down payment – the first in a succession of downward adjustments. But, in that case, they violated the first rule of exchange-rate management: Don’t cut off a cat’s tail in slices.

The rationale for this rule is straightforward: If foreign investors expect that more currency depreciation will follow, they will rush out of Chinese markets to avoid further losses. Capital outflows will accelerate, financial conditions will tighten, and investment will suffer. In fact, this is precisely what China is experiencing.

A single large devaluation that gets the entire adjustment out of the way minimizes this risk. Indeed, if investors expect the sharp improvement in competitiveness to lead to stronger economic performance, the currency will recover some of its lost value. Capital will flow in rather than out. Spending will rise rather than fall, which is precisely what China needs in the current circumstances.

Instead, by resorting to their traditional incremental approach, Chinese policymakers undermined confidence that they know what they are doing. Because they adjusted the exchange rate without describing their motives, they merely encouraged the belief that China’s economic performance is even worse than official data suggest.

Well, it is always difficult to guess the right amount if devaluation. Market expectations are as weird as it can get. They mostly get things wrong and then react in a knee jerk fashion making a mockery of the policy. Then at a time not too long ago, China was criticised for not letting its currency appreciate. Renminbi was seen as a highly undervalued currency which boosted Chinese exports artificially.

What times we are living in. Whatever you think cannot happen, is happening.


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