China's Yuan Devaluation Is Dangerous - For China
China’s devaluation of the yuan made headlines recently when the value went past the key seven yuan per dollar level. Since reaching that level, the yuan has continued to slide to 7.16 today. China is devaluing the yuan to offset the U.S. tariffs (more details here about why exactly China devalued the yuan and how this boosts their exports). However, although devaluation can blunt the blow of the tariffs, it is a dangerous move for China with difficult trade-offs.
Firstly, the move is morphing the trade war into a currency war. The U.S. treasury has labeled China a currency manipulator and there is serious talk of the U.S. intervening in the currency markets to strengthen the Chinese yuan and weaken the dollar. And this is not something the Chinese can count on going away if they can outlast Trump - both Donald Trump and Elizabeth Warren want the dollar to be weaker.
China’s Debt Burden
However, China begins to run into real problems with devaluing their currency when you consider the massive – truly massive – amount of debt the nation took on in the wake of the Great Recession. Jamil Anderlini, writing in the Financial Times, explains that:
In the aftermath of the global financial crisis, China’s manufacturing and export dependent economy crumbled and the ruling Communist Party panicked. Party leaders estimated they needed to sustain a minimum annual growth rate of 8 per cent if they were to contain political unrest that could threaten authoritarian rule. The solution was to unleash what economists have called the greatest example of monetary easing in history — an enormous wave of easy loans channeled through the state-owned banking system
Indeed, since 2008, Chinese debt has exploded from 7.7 trillion to 33 trillion today (adjusted for inflation) – an almost doubling of their debt as a percent of GDP (perhaps more as China’s GDP numbers are suspect).
Critically, much of this debt is denominated in dollars. Currently China’s total outstanding dollar-denominated debt is estimated to be around 3 trillion USD (or roughly 27% of China’s GDP). Moreover, Bloomberg just reported the other day that “The foreign debt built up by Chinese companies is about a third bigger than official data show, adding to the pressure on the country’s currency reserves as a wave of repayment obligation approaches in 2020”
This puts the People’s Bank of China (PBoC) in a difficult position. If it devalues China's currency to offset the tariffs, it will make it increasingly difficult for Chinese companies to pay their dollar-denominated debt. And although China still has large foreign exchange reserves (largely as a consequence of their currency manipulation in years past) their reserves have fallen from a high of 4 trillion in 2014 - to roughly 3 trillion today – a steep drop as a percentage of GDP and a level that arguably may be insufficient given the size of their economy.
An even larger potential downside of the devaluation for China is the specter of capital flight. China has already quietly begun to limit the amount of dollars that Chinese citizens can withdraw from their accounts and crack down on capital outflows from the country even more than before. However, many analysts are concerned that capital flight could be an enormous problem for China if they continue to devalue the yuan. Capital flight is particularly dangerous because if confidence is lost and money begins to flee the country the process can quickly build on itself and spiral out of the control of Chinese authorities.
Between a Rock and a Hard Place
All of this leaves the PBoC with the choice between allowing the Chinese economy to slow down without further stimulus and face the full impact of American tariffs, or devalue the yuan which would put Chinese companies that owe dollars in a difficult situation and potentially lead to politically destabilizing inflation in China if capital flight accelerates.
The difficulty of this choice is compounded by China’s ongoing agricultural crisis. Pork is China's most popular meat - but over the last few months the African Swine Flu has destroyed 22% of the Chinese pig population and it is estimated that this will increase with China being force to cull nearly 50% of their pigs by the end of the year. The country is also dealing with an army worm infestation. According to the USDA Foreign Agricultural Service, the armyworm has:
...no natural predators in China and its presence may result in lower production and crop quality of corn, rice, wheat, sorghum, sugarcane, cotton, soybean, and peanuts among other cash crops. Experts report that there is a high probability that the pest will spread across all of China’s grain production area within the next 12 months
China has already seen a spike in food prices because of these issues, and Chinese officials are suggesting the pork prices could ultimately rise 70%. Not only will Beijing be forced to pull from its dollar reserves to import additional food, but food inflation in China is likely to increase regardless. In fact, food inflation has already spiked to 9.1% as of July.
China’s Worst Fear - Civil Unrest
The New York Times recently highlighted the many challenges now facing Beijing and it noted the sharp increase in food prices – and how food inflation back in the late 80s was a key part of the Tiananmen Square protests.
The current Hong Kong protests are also at least partially fueled by anger with economic conditions. Both the NYT and CNBC have excellent recent articles tying the ultimate force behind the ongoing unrest in Hong Kong to economic frustration.
Although the unrest in Hong Kong has gained worldwide attention, many incidents of unrest in mainland China have not gotten the same coverage. As the economy has slowed, anger with the Communist government has increased sharply. The New York Times reported back in February how:
Factory workers across China are staging sit-ins demanding unpaid wages for “blood and sweat.” Taxi drivers are surrounding government offices to call for better treatment. Construction workers are threatening to jump from buildings if they don’t get paid.
With economic growth in China weakening to its slowest pace in nearly three decades, thousands of Chinese workers are holding small-scale protests and strikes to fight efforts by businesses to withhold compensation and cut hours.
Beijing fully realizes that the government’s claim to legitimacy is based on economic growth. They were forced to run up a massive debt after the 2008 financial crisis to prevent widespread unrest in the country.
The slowing Chinese economy, the rise in food prices - and the risk of even more inflation to come – puts Beijing in a difficult situation. The trade war (now arguably currency war) has come at the worst moment for the country. China’s increasing debt makes devaluation a difficult choice. China may need to devalue the yuan - but a significant devaluation could have serious consequences for China and the rest of the world.
If Beijing does continue to weaken the yuan, it would be economically destabilizing, not just for China, but for many other countries and geopolitically destabilizing for the world. The Trump administration was already talking about additional currency tariffs that could be imposed if China devalues their currency further – and that was before the yuan devalued below 7 yuan per dollar.
The situation is fraught with danger for the Chinese government who must maintain a strong economy for political reasons at all costs. All of its options are dangerous and any emerging crisis would be unlikely to stay localized to China. Today, China is the second largest economy in the world. As the former chief economist at the IMF, Kenneth Rogoff said “If there’s a country in the world which is really going to affect everyone else and which is vulnerable, it’s got to be China today.”
Although – with the recent resignation of the Italian Prime Minister, Italy is another contender.
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About the Author Joshua Konstantinos Founder and Global Macro Strategist at Cassandra Capital LLC and author of Sleeping on A Volcano: The Worldwide Demographic Upheaval and the Economic and Geopolitical Implications,
Joshua has been obsessively following global trends and collecting data for over a decade. His analysis takes into account not only the larger view of the rapidly changing global economy but also the longer demographic and geopolitical trends.