• Joshua Konstantinos

Why Did China Just Devalue the Yuan?

How International Trade Works with Free-Floating Currencies - Everything you need to know about the Motivations and Implications of the Currency Shift.

Recently China allowed their currency to fall below the key level of 7 yuan per dollar. But what does that mean for a currency’s value to change? And what benefit does China gain from this move?

Before we can really answer that question, we need to understand what it means for a currency’s value to change - and how a currency valuation impacts the global economy. In today’s world currencies are free-floating - which just means that the value of currencies relative to each other can change. It wasn’t always this way. Under the old gold standard currencies would all be convertible into gold. And after World War II, the Bretton Woods Agreement established fixed exchange-rates with currencies pegged to the dollar. But after that system broke down, nations abandoned the peg to the dollar and floated their currencies.

Purchasing Power Parity

With currencies now floating, the relative value of a currency suddenly mattered. Under the current free-floating monetary system, the prices of currencies themselves can be manipulated - which affects the calculation of comparative advantage for trade. Currencies can be undervalued or overvalued relative to each other. One might logically suppose that when six Turkish Lira can be exchanged for one American dollar, the actual purchasing power of one dollar would be roughly the same as six Turkish Lira. In other words, if a cheeseburger cost $5 in the United States, when you exchange currency you may get ¥500 yen, but a cheeseburger in Japan should then cost roughly ¥500 yen. But this is not the case. Many nations manipulate the currency exchanges to undervalue the purchasing power parity (PPP) of their own currencies. Making everything priced in their currency cheaper to buyers from foreign countries. This is the reason that China purchased so much U.S. government debt - China bids up the price of the dollar relative to the yuan by buying dollars with yuan, and then sits on these dollars by purchasing U.S. treasuries with them. This is why the idea that you sometimes hear that China could hurt the U.S. by selling off their treasury holdings is totally backward. If they sold their dollar denominated U.S. debt for yuan the value of the yuan would spike and deeply damage their export economy. Both Donald Trump and Elizabeth Warren want the dollar to be weaker because, as we will see, a weaker currency will boost exports.

Currency Value and International Trade

Not surprisingly, the abrupt and dramatic change in how international currencies functioned had a significant impact on world trade after the Bretton Woods system broke down. And especially for China. As Brian Reinbold and Yi Wen of the Federal Reserve of St. Louis explain:

The long-running U.S. trade deficits and the emergence of China as a major creditor nation to the U.S. seem to be the result of two major economic forces: (1) the breakdown of the Bretton Woods system, which caused the U.S. currency and U.S. government debts to become the world currency and a global form of liquidity and store of value; and (2) the shifting of comparative advantage in goods production, which caused the reallocation of labor-intensive manufacturing from the U.S. to nations with cheaper labor.

Later we’ll will see that this “shifting of comparative advantage… to nations with cheaper labor” is also related to the breakdown of the Bretton Woods system. But for now, let’s consider how trade works with free-floating currencies. One country can manipulate their currency lower so that everything they produce is significantly cheaper from the perspective of other countries. This distorts the idea of comparative advantage because prices are no longer reflective of the underlying economic reality. Prices are no longer a function of supply and demand or relative efficiency. With manipulated currencies it is impossible to even know if resources are being allocated more efficiently or not.

Think about it. Let’s say one country actively manipulates their currency exchange rate so that all of a sudden everything in their country is cheaper to buy with dollars. Canada could do it tomorrow – the bank of Canada wants a cheaper Canadian Dollar so they go and buy US dollars and sell Canadian dollars. Did they suddenly gain a greater comparative advantage? Will they be able to produce more efficiently? Regardless, Canadian exports will rise and production will move to Canada regardless of if that is actually the most efficient allocation of resources.

Currency Manipulation Does Affect the Trade Balance – Although Indirectly.

Now, there is actually a great deal of confusion around this issue. Some economists will tell you that currency exchange rates are inconsequential for trade balances. For example, the 1998 testimony to the Subcommittee on International Economic Policy and Trade Committee on International Relations, where Daniel Griswold of the CATO Institute said:

The most important economic truth to grasp about the U.S. trade deficit is that it has virtually nothing to do with trade policy. A nation’s trade deficit is determined by the flow of investment funds into or out of the country. And those flows are determined by how much the people of a nation save and invest - two variables that are only marginally affected by trade policy .

On the first point, he is correct. Trade flows are determined by how much the people of a nation save and invest. But, in reality, such capital flows are actually highly impacted by trade policy.

To understand the link between the national savings rates and the trade balance, you need to look at the economy as a whole. In economist lingo the national savings S minus the total investment I is equal to the total exported goods X minus the total imports M. with the formula being: S-I = X-M. That may seem a bit confusing - but think of it this way, if a nation produces a certain amount of value - they can either consume that value, invest than value, or export that value. The less value a nation consumes, the higher their savings rate is, the more they have available for investment and exports.

So, Canada’s trade balance - the balance between their imports and their exports - is really a function of their levels of savings and investment. Canada produces a certain amount of goods and services, but imagine that they have a fantastically high savings rate and they consume little of what they produce, what happens to the goods and services that they created? That value must either be consumed, invested, or exported. So, the higher their savings rate is, the higher exports will tend to be. And of course the reverse is true - if Canada consumes more than it produces it must obviously import goods and services.

It is this analysis that causes some to argue that tariffs and currency manipulation will have no impact on the trade balance of a nation, because while an artificially low currency might change comparative advantages, it is the savings and investment rate that affects the trade balance on the whole. But what is missed in this analysis is that the high savings rates, as seen in China for example, are the result of policies that suppress domestic consumption - like an artificially low currency.

As Michael Petteis describes in his fantastic book, The Great Rebalancing, nations have created policies which suppress consumption - thus boosting exports, ultimately creating the massive trade imbalances we see today between nations. He writes:

Many Asian countries have followed the growth model established in the 1960s and 1970s by Japan, and this growth model includes crucially these three conditions:

1. Systematically undervalued currencies, in which the central bank intervenes in the currency to reduce its exchange value

2. Relatively low wage growth, in which wages grow more slowly than improvements in worker productivity

3. Financial repression, in which the state allocates credit and the central bank forces interest rates to below their natural or equilibrium rates.

All of these actions suppress household consumption - moving value from the household sector to the goods producing sector. As he explains:

…an undervalued currency, by raising the cost of imports, acts as a kind of consumption tax for household and so reduces disposable household income. With lower disposable household income usually comes lower household consumption…the combination of lower consumption and higher production automatically causes a surge in the savings rate.

And of course, this also acts as a subsidy to consumption for other countries whose currencies can now purchase additional imports.

The Imbalanced World

With the consumption suppressing/export driven growth models enabled by free-floating currencies, trade imbalances have become a defining feature of the last fifty years. Lord Mervyn King, former Governor of the Bank of England, described how today’s massive trade imbalances have divided the world:

The surpluses are concentrated in four countries - the euro area, China, Japan and Korea. Taken together, their combined current account surplus in 2016 was $886 billion, just over 3% of their GDP. The deficits were also concentrated in four countries – the United States, United Kingdom, Canada and Australia. Their combined deficits were $680 billion, just under 3% of their GDP. It is a striking example of the difference between the two “groups of four”: the Anglo-Saxon world, with its instinct of openness to trade and competitive financial markets, and Continental Europe and the Far East, with a more mercantilist outlook.

Under the current free-floating monetary system, imports and exports are no longer balanced between nations. Trade is no longer balanced by gold (which despite its faults did balance trade) or through the fixed exchange rates of the Bretton Woods system that was created after World War II. Today a country can manipulate its currency lower and run trade surpluses for decades - leading to a larger and larger trade deficits.

This is precisely what has happened to the United States over the last fifty years since the end of Bretton Woods. A massive trade deficit was created in the United States. And a tremendous amount of U.S. manufacturing jobs were outsourced - with almost no counter-balancing increase in other sectors on the U.S. Economy. Such an outcome defies classical economic logic - but is possible because of the breakdown of the Bretton Woods monetary system in 1971.

Back to China

Now that we understand how free-floating currencies function, and how they can impact trade balances, we can understand why China devalued the yuan and what the implications are.

Firstly, China has devalued the yuan to offset the rising tariffs that the United States has been imposing. In fact, China has devalued the yuan significantly since the Trump administration first placed a 10% tariff on Chinese goods – effectively negating the tariffs. And with the new 10% tariffs that Trump has promised to imposed on a wider range of goods China has in response devalued their currency further.

This escalates the Trade War potentially into a currency war, but in an additional wrinkle, although China massively devalued their currency for years - economists note that today China is actually supporting the value of the yuan. Strengthening it. They did not have to act to weaken the yuan below the key 7 yuan per dollar level, they merely allowed it to happen.

To understand why they would now be strengthening the yuan, you have to understand how, since the Great Recession, China has been accumulating massive amounts of debt. 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.

Critically, China has also taken on a large amount of dollar denominated debt. Currently China’s total outstanding dollar-denominated debt is estimated to be around 3 trillion USD (or roughly 27% of China’s GDP).

These dollar denominated debts puts the People’s Bank of China (PBoC) in a difficult position. With China’s economy slowing down, China may need to further stimulate its economy – or risk problems in its own banking system.

In April 2019, Mike Bird’s article, China’s Banks Are Running Out of Dollars, in The Wall Street Journal highlighted the fact of China’s growing debt denominated in dollars, and their increasing need for dollars writing “The major Chinese commercial banks once had more dollar assets than liabilities. No longer.”

In May 2019, Bloomberg published The Dollar Dictates China’s Need for a Trade Deal: The country’s exploding foreign debt means it has to keep hard currency coming in. In the article, the author Christopher Balding makes a strong case that China may be forced to negotiate a trade deal with the US because they will be unable to service their debts without bringing in dollars. He writes:

In 2018, China’s deficit with the U.S. was equal to 92% of its entire goods trade surplus. As a matter of economics, the bilateral trade deficit has little importance – contrary to what Trump often argues. But to China, the ability to generate hard international currency is vital.

China’s external debt stood at $1.96 trillion at the end of 2018 and has probably crossed the psychologically important threshold of $2 trillion since then. The country now needs more than $100 billion annually to service foreign debtors. The pressure to cover offshore borrowing and investing in hard currency is creating an increasing shortage of dollars in Chinese banks, which have been used for a variety of political purposes .

China has been able to maintain its system thus far, and may be able to maintain it longer than many expect, because unlike every other major economy, China has strict capital controls. Yuan is not able to escape China, and therefore while other countries might see capital flee the country long before the point China has reached, China has been able to prevent a collapse of its currency.

However, in May 2019 the South China Morning Post reported that Chinese banks had quietly lowered the daily limit on foreign-currency cash withdrawals - a sign that China may be feeling the squeeze of the trade war and feeling the effects of capital flight despite their controls.

Key Takeaways

In the final analysis, China devalued their currency to offset the U.S. tariffs. But China is between a rock and a hard place. Tariffs risk severe damage to their fragile economy if not offset with currency devaluation. But, with the enormous debt burden the Chinese are now under, currency devaluation creates the real risk of capital flight from the country - and makes it more difficult for China to service its dollar denominated debt.

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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.

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