12 August 2015

Q&A: Has China started a currency war?


1. What has happened?

China has stunned financial markets by intervening in global currency markets to force down the price of its currency, the Renminbi, for the second day running. Together with yesterday’s intervention by the People’s Bank of China (PBOK), the Renminbi is now 4% cheaper against the trade-weighted US dollar, after having stabilised at 6.2¥ to the dollar for months.  This follows news last week that Chinese exports fell by 8.3% in July, turmoil in Shanghai’s stock markets, and doubts raised over the validity of China’s growth statistics .

2. Are we seeing the return of beggar thy neighbour politics?

During the depths of the Great Depression in the 1930s and before the Bretton Woods Agreement in 1944, many countries, looking to speed up their recoveries by boosting exports, started to renounce the Gold Standard – a deflationary global fixed exchange rate system that many economic historians such as Barry Eichengreen blame for prolonging the crisis. Britain cut its ties with the Gold Standard in 1931 after a disastrous nine years with an overvalued rate. In 1933, Franklin Roosevelt decoupled the direct link between money and gold and by raising the dollar price of by 69% effectively devalued the dollar by the same rate. The Italian lira fell by 20% between 1935-37, and in 1938 France allowed the franc to depreciate by 28%. According to a Bloomberg Briefing note from 2013, most advanced economies engaged in currency devaluations of at least 10% in the 1930s.

The Chinese devaluation of 4% in the last two days is significant and represents the biggest one-day movements in a single currency for 20 years. It comes amid a backdrop against which the trade-weighted US dollar has appreciated by 36% in the last four years

Bloomberg reports:

Today’s decision “raises the distinct possibility of a new and increasingly destabilizing skirmish in the ever-widening global currency war,” according to Stephen Roach, the former non-executive chairman for Morgan Stanley in Asia who’s now a senior fellow at Yale University. Economists at JPMorgan called the move a “Pandora’s box” which China’s neighbors will view as a “competitive devaluation.”

As the world economy struggles to generate enough demand, policymakers around the world have turned to monetary stimulus to provide a boost. In Q1 2015, over twenty countries cut interest rates and the ECB started its €1.1trn QE programmed. One of the main mechanisms through which looser monetary policy works is the exchange rate. As more new currency is created, its value falls in world markets, making exports comparatively cheaper and imports more expensive. Following his introduction of capital controls in 2009, Brazilian Finance Minister, Guido Mantega, was the first leading statesman to mention an ‘international currency war’ in 2010, after the Federal Reserve’s QE programme started harming Brazilian exporters.

Yet what we’ve seen in the last couple of days still pales into insignificance when compared with the experience of the 1930s. We’re not likely to see President Obama dust off the Smoot-Harley Tariff Act to protect exporters. Nevertheless, officials should always remain sceptical of the ability to use currency devaluation to “steal” growth from other countries. Currency wars are a zero sum game with an equilibrium which benefits no-one and, as the 1930s experience showed, can lead to worse outcomes for the global economy.

3. Is China actually preventing the Renminbi from falling further? 

Gavyn Davis at the Financial Times takes a different view of China’s latest move in global markets. With falling business confidence, he reports that China’s interventions in foreign exchange have been to stem the outflows of capital.

“Reserves have fallen by about $340bn since the peak in early 2014. This has resulted in an unintended tightening in the domestic money markets, which has been offset by reductions in reserve ratio requirements on the domestic banks. More cuts in the RRR are likely soon. But the PBOC has found it increasingly difficult to ease monetary policy as inflation has fallen and the economy has slowed.

“[China] sees no advantage in starting a genuine currency war. But it no longer has to manipulate the currency market in order to achieve a devaluation. All it has to do is to stop manipulating the free market, and capital outflows will probably take the exchange rate much lower. There will be complaints from the Republicans in Congress, but their case does not seem as compelling as it once was.”

In other words, China is managing the weakening of the Renminbi in what is known as a “crawling downward peg”. Having a relatively expensive currency has advantages for China. It helps the country to rebalance away from price-sensitive low-cost manufacturing and promote sectors higher up on the value chain. It also promotes consumption, reduces the cost of capital imports and encourages foreign governments to use the Renminbi.

While there is a lot of credit to this explanation, we cannot entirely discount the advantage of a counter-cyclical policy which would boost short term growth without destabilising China’s creaking banking system.

4. What does this mean for interest rate rises in the US and UK? 

Gavyn Davies also notes that Beijing’s recent willingness to allow its currency to rise with the dollar (that is, pegging it recently at 6.2¥ to the dollar) has enabled it to export much needed inflation to the Eurozone and the UK. By reducing the cost of imports to these regions, prices will be subdued and could lead to a further delay in interest rate rises.

5. Does this affect the future of the Renminbi as a global currency? 

“The People’s Bank of China has orchestrated a clever combination of a move to weaken the renminbi with a shift to a more market-determined exchange rate, blunting foreign criticism of the renminbi devaluation,” said Eswar Prasad, the former IMF country head for China.

The decision clearly pulls in both directions. The market is probably trending downwards but these unexpected interventions do not engender trust among international investors. To establish the Renminbi as a global reserve currency, however, much more need to be achieved. Beijing would need to liberalise markets in short-term government debt and run large trade deficits to meet demand for the currency. It would also need to promote the rule of law much more aggressively. While a greater role for the Renminbi could boost China’s economy, there are a number of obstacles still in the way.

Zac Tate is Deputy Editor of CapX