What Happened: People's Bank of China devalued the Rmb, setting the rate 1.9% lower on August 11, and a further 1.1% the next day - the biggest fall for the Rmb since the 33% devaluation in the first week of 1994, and seemingly an abandonment of prioritising early inclusion in the SDR over the needs of the domestic economy.
Why It Matters: This is an important development both for China (its economy and politics), for the rest of Asia, and for the world economy. Let's take them separately. For China, the decision to devalue marks the abandonment of two linked policy goals. First, and most obviously, it is an acknowledgement that the economic sacrifice made in demonstrating sufficient stability for the Rmb to be included in the SDR at an early date, is proving too burdensome. Or, to be blunt, it acknowledges the error of allowing the Rmb to be dragged up with the dollar last year, without an aggressive easing in other areas of monetary policy.
Second, and less obviously, it marks the end of the carefully assembled illusion that sufficient foreign reserves and a sufficiently conservative set of banking policies could allow China to escape indefinitely from the monetary policy trilemma (the one which makes a fixed currency, open capital account and independent monetary policy an unstable triad). Both of these mean that a serious policy re-think is now inescapable.
Politically for China, the stockmarket's fall followed by the predictable devaluation of the Rmb demonstrates two things: first, it tells the Party that it cannot control the Market; second, it tells the Chinese people that the Party cannot control the Market. Given that the Party treasures control above all else, this represents a genuine political crisis. So in short, this is a moment of profound challenge and, ultimately change, for China's political economy.
For Northeast Asia, the problem is very simple: China accounts for just over 70% of Northeast Asia's combined exports. If China is devaluing in order to maintain its export position (a subsidiary aim, with the principal aim being to raise utilization rates in an economy which has been driven by the growth of capital stock), then export prices will be cut for every other Northeast Asian trading partner and competitor. The deflation which so far has been largely confined to commodity markets, will spread more rapidly to Asian manufactures, starting now. Within Northeast Asia, Japan is the most obviously vulnerable, having tried for two and a half years to ginger up its economy via devaluation. China has just trumped that strategy.
For the rest of the world, there is the uncomfortable fact that in dollar terms, during the five years to 2014, China accounted for 54% of the total growth in GDP for the G7 and BRICs combined. Or put it another way, between 2010 and 2014, China's dollar GDP grew 71.5%, whilst the rest of the G7 and BRICs expanded just 9.8%. Depending on how far China ends up devaluing, those numbers are going to change, and quite possibly dramatically.
And finally, and again obviously, China's devaluation is likely to trigger a whole new round of Asian-sourced deflation in the traded goods sector. Bond markets have made their initial reaction, western monetary policymakers will be re-casting their sums.
What Happens Next? Why It Matters: This is an important development both for China (its economy and politics), for the rest of Asia, and for the world economy. Let's take them separately. For China, the decision to devalue marks the abandonment of two linked policy goals. First, and most obviously, it is an acknowledgement that the economic sacrifice made in demonstrating sufficient stability for the Rmb to be included in the SDR at an early date, is proving too burdensome. Or, to be blunt, it acknowledges the error of allowing the Rmb to be dragged up with the dollar last year, without an aggressive easing in other areas of monetary policy.
Second, and less obviously, it marks the end of the carefully assembled illusion that sufficient foreign reserves and a sufficiently conservative set of banking policies could allow China to escape indefinitely from the monetary policy trilemma (the one which makes a fixed currency, open capital account and independent monetary policy an unstable triad). Both of these mean that a serious policy re-think is now inescapable.
Politically for China, the stockmarket's fall followed by the predictable devaluation of the Rmb demonstrates two things: first, it tells the Party that it cannot control the Market; second, it tells the Chinese people that the Party cannot control the Market. Given that the Party treasures control above all else, this represents a genuine political crisis. So in short, this is a moment of profound challenge and, ultimately change, for China's political economy.
For Northeast Asia, the problem is very simple: China accounts for just over 70% of Northeast Asia's combined exports. If China is devaluing in order to maintain its export position (a subsidiary aim, with the principal aim being to raise utilization rates in an economy which has been driven by the growth of capital stock), then export prices will be cut for every other Northeast Asian trading partner and competitor. The deflation which so far has been largely confined to commodity markets, will spread more rapidly to Asian manufactures, starting now. Within Northeast Asia, Japan is the most obviously vulnerable, having tried for two and a half years to ginger up its economy via devaluation. China has just trumped that strategy.
For the rest of the world, there is the uncomfortable fact that in dollar terms, during the five years to 2014, China accounted for 54% of the total growth in GDP for the G7 and BRICs combined. Or put it another way, between 2010 and 2014, China's dollar GDP grew 71.5%, whilst the rest of the G7 and BRICs expanded just 9.8%. Depending on how far China ends up devaluing, those numbers are going to change, and quite possibly dramatically.
And finally, and again obviously, China's devaluation is likely to trigger a whole new round of Asian-sourced deflation in the traded goods sector. Bond markets have made their initial reaction, western monetary policymakers will be re-casting their sums.
We shall see. At present, Chinese sources are glossing the devaluation merely as an extension of China liberalizing its economy. Whilst one can't rule out completely that the end-result may yet be that, it defies belief that this is the motivation. Rather, for the reasons given above, this is a moment of profound challenge for China's policymakers, and how the various tensions, problems and opportunities will play out is, for now, anybody's guess.
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