Imagine if free markets were allowed to be free.
Of course, in today’s world, they’re not. Central bankers and government agencies have taken control. Not knowing what to do with it hasn’t stopped them.
China is the latest case in point. We recently suggested that investors worry about China, not about Greece, although for a tiny country Greece gives everyone plenty to worry about. But China should be the center of everyone’s attention, given its attempt to fix its falling stock market and boost imports by devaluing the yuan.
While it’s impossible to guess the intentions of China’s rulers – and they’re not about to share them – the 1.9% devaluation announced last week smacks of desperation. China’s stock market has been swooning this summer and its exports are down by 8.3% (much larger than the expected 1.5% decrease), which is not good for future growth.
In addition, The Wall Street Journal noted, “Pockets of manufacturing have been especially hard hit, as reflected in sluggish electricity use and falling rail cargo. Especially scary is the prospect of deflation; producer prices were down 5.4% from a year ago.”
China’s largest devaluation of the yuan in two decades will make exports cheaper for foreign consumers of Chinese goods, including Americans, but it will also reduce the purchasing power of Chinese consumers, who will likely consume less as a result.
One Fix or More?
While officials claimed the devaluation is a one-time fix, under a new system of “daily fixes” (irony unintended), more may be coming.
The Wall Street Journal cited three potential interpretations for the devaluation:
- The optimistic interpretation. China believes the yuan is overvalued compared with the currencies of its trading partners, and its central bank is liberalizing controls to allow market forces to play a larger role in day-to-day trading.
- It’s the Fed’s fault. The U.S. Federal Reserve’s quantitative easing “flooded the world with cheap dollar liquidity and now is poised to spark crises in emerging markets as it raises interest rates.” This would mean China is seeking to delink from the rising dollar more than it is trying to devalue the yuan.
- Join the currency war. China may be joining “the wave of beggar-thy-neighbor devaluations sweeping the region,” which could have a detrimental impact on both China’s growth and global economic growth.
Regardless of the reason – or reasons – for the devaluation, it’s more likely to harm the economy than it is to help it. When a country debases its currency, it typically causes economic pain, not economic gain.
“Every country in modern human history has tried this,” Hedgeye CEO Keith McCullough said on The Macro Show. “You’ll note that it hasn’t worked.”
For example, in 1997, after keeping their currencies stable for a decade, Thailand, Indonesia and South Korea each tried to devalue their way out of a crisis.
“The result was a capital stampede that exhausted reserves and led to high inflation,” according to The Journal. “Domestic institutions that had borrowed in dollars found themselves unable to service debts. The dislocation damaged exports and their economies.”
Consider some of the potential problems the devaluation of the yuan will likely cause:
- It will increase volatility and pressure on the yuan
- It will discourage foreign investment
- It will encourage citizens to store savings abroad
- It will weaken consumer spending
- It could result in contagion globally
“The devaluation has diminished the global buying power of Chinese savers by 1.9% at a stroke, which hardly encourages consumption,” The Journal concludes. “And it signals that manufacturers will continue to receive state support.”
In the U.S., the devaluation could cause the Fed to continue to delay an interest rate increase.
As The New York Times noted, “The yen, the euro and several other major currencies have fallen in recent years against the dollar as the Federal Reserve has cut back its stimulus and policy makers elsewhere have sought to obtain gains for their sluggish national economies.”