You can’t always get what yuan…

By Robert Z. Aliber

Currency wars and the latest Chinese devaluation.

China’s currency devaluation has made waves this week — and has led to a lot of feverish head-scratching. The puzzle, however, is not that China has reduced the price of the yuan, but that the devaluation has been just two percent at a time when the prices of the currencies of the countries that account for more than half of world trade have fallen by 20 percent.
China continues to have a whopping great trade surplus, mainly because import prices have declined sharply and import volumes have fallen. Lower import prices mean that some of the material costs of export industries have fallen, but any boost to China’s export competitiveness has been negated by the manipulation of the yen and the euro. As Beijing knows, the currency game is global.

China’s two percent devaluation will lead to a sharp increase in capital flight. Wealthy entrepreneurs and the political class will have concluded that it was too little and too late. And the inevitable response will be much sharper reductions in the price of the yuan. Fasten your seatbelts…

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In any analysis of this kind, some background never hurts. In December 2012  Prime Minister Shinzo Abe started a currency war when he “talked down” the price of the yen by 20 percent even though Japan had been growing by one-and-a-half percent a  year and the unemployment rate was four percent. Abe believed that as the price of the yen fell, Japan’s exports would increase, and the country’s current account surplus would increase from two to four or five percent of its GDP (which would lead to a sharp decline in its fiscal deficit).
Within the last eight months, the U.S. dollar price of the euro has declined by more than 20 percent, even though the eurozone countries as a group have a current account surplus of two percent of their GDPs. Matteo Renzi, prime minister of Italy, suggested that the euro might go to “parity” — $1 would equal €1  — which was a prescriptive statement to talk down the price of a seemingly overvalued currency.
Beyond Europe, there is the raw material “hinterland:” As the prices of petroleum, iron ore, and other primary products have declined, the prices of the Canadian dollar, the Australian dollar, and the Brazilian real have fallen sharply. Because the price of the Chinese yuan has been pegged to the U.S. dollar for the last five years, exports from China to Japan, the eurozone countries, and to Brazil and Australia are negatively impacted by the declines in the prices of the yen, the euro, and the currencies of the countries that produce petroleum and other primary products.

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There’s even more history.
The currency war that was started by Prime Minister Abe nearly three years ago is a reminder of the staggered reductions in the prices of currencies in the 1930s, which led to the cliché that countries were following “beggar-thy-neighbor” policies.
Chile and Argentina went off the gold standard at the end of the 1920s when their export prices declined sharply and they could no longer borrow abroad to finance their trade deficits. Austria devalued the schilling in May 1931 in response to a speculative attack. The speculative pressure was deflected to the British pound, which gave up trying to maintain its parity in September 1931. The United States then experienced a run on the dollar, and the dollar price of gold was increased from $20.67 to $35.00 to promote U.S. exports.
The declines in the prices of the currencies in the 1930s were self-defensive, each country responding to the loss of exports and the challenge of a speculative attack. In contrast, the contemporary declines in the prices of the Japanese yen and the euro have occurred even though both currency areas have large current account surpluses.
The two primary drivers of China’s rapid economic growth in the last 10 years have been investment in real estate and exports. The real estate market is in turmoil, with more than 10 ghost cities, and a high number of unoccupied apartments. Real estate prices are declining, and the fall in household wealth has led to sharp reductions in the demand for automobiles and other durables. Household wealth will diminish further as the clumsy efforts to manipulate stock prices unravel. Millions of wealthy Chinese are moving more of their financial wealth to Hong Kong, London, and the United States. Call it a “Great Migration…of capital.”

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Is there an objective truth in all of this? If the IMF were still the sheriff for determining whether a country could reduce the price of its currency, it would have concluded that neither Japan nor the eurozone countries were in fundamental disequilibrium, and that the proposed declines in the prices of the yen and the euro were unacceptable. The “beggar-thy-neighbor” charge is more fully applicable to the events of the last several years than it was in the 1930s.
All wars — even currency wars — must end. This currency war will become more intense before it inevitably abates. The United States and its major trading partners will conclude that they need a new set of rules that will limit the ability of countries to grow their way out of their domestic problems at the expense of their neighbors. As for China, it will need to live with a sobering global truth: You can’t always get what you want.