In the 2000s, a common complaint against China was its weak peg against the dollar and its accumulation of foreign exchange reserves including dollar-denominated assets, which devalued the yuan against the dollar, cheapening the prices of its exports to the U.S. while increasing the prices of imports to China.
So in 2010, Beijing started to let the yuan appreciate, going from about 6.8 yuan for 1 dollar to 6.05 for 1 dollar by the end of 2013. That represented more than a 12 percent rise in the Chinese currency’s value.
Then, on top of that, in mid-2014, the dollar started appreciating rapidly — a flight to safety was occurring into U.S. dollar assets including treasuries and other bonds amid weakness in Europe and the popping of the credit bubble in China — and, thanks to the yuan’s weak peg relative to the dollar, it took the yuan up with it. In this run, the dollar has appreciated 32 percent.
Soon, economists who had been hard on China, such as New York Times columnist Paul Krugman in 2010, were suddenly saying that the yuan was now overvalued by the summer of 2015.
Since that time, the Shanghai Composite Index has undergone a major correction of more than 40 percent off its June 2015 highs — that is, it crashed — and certain devaluation measures have been deployed by Beijing. Instead of 6 yuan for 1 dollar, as at the beginning of 2014, it has risen to about 6.46 yuan per 1 dollar now, a more than 7 percent devaluation.
But that’s not enough, Yu Hongding, director of the Chinese Academy of Social Sciences and a former Bank of China rate-setter, told the UK Telegraph’s Ambrose Evans-Pritchard. “They must stop intervening on the exchange market. China needs to devalue by 15 percent,” said Yu, warning that Beijing was risking burning through its foreign exchange reserves, which have dropped from $4 trillion to $3.2 trillion since the correction began.
“Reserves will continue to fall until we devalue. Once we get towards $2 trillion the markets will start to panic,” Yu warned.
All of which reveals the perils of China’s weak dollar peg and overall devaluation policy. In the 2000s, when the dollar was falling against other currencies and China was accumulating its foreign exchange reserves, the policy seemed to help fuel the boom in China. But with the sharp rise of the dollar, now it has helped prompt the bust.
Which, live by the fixed exchange rate, die by the fixed exchange rate, we suppose. China is reaping what it sowed, for it was Beijing’s desire to boost exports that prompted its weak dollar peg and stockpiling of foreign exchange reserves in the first place.
While technically the yuan is still cheaper than the dollar, the dollar’s relative strength has buoyed it up against other major currencies. For example, the yuan is up more than 17 percent against the euro since 2014. It had been up as much 22 percent against the Japanese yen from 2014 to 2015, before settling back down in recent months, although it is still up almost 40 percent against the yen from its 2011 level.
To keep its competitive edge, China may desire to engage in rampant devaluation once again to boost its exports. But do policymakers there even have any idea what the proper value of the yuan even is? What other economic harms will these distortions set off?
It’s almost as if they’d be better off with a floating exchange rate. Markets are clearly signaling they believe that the yuan is overvalued. Which do we suppose would be faster in correcting that imbalance, traders or central bankers?
In the meantime, to the extent Beijing gets it wrong, with public attitudes in the West shifting against Beijing’s de facto tariffs against its trade competitors, this time its actions really might set off a trade war. How this ends is anyone’s guess.
This is a guest post by Robert Romano senior editor of Americans for Limited Government.