China devalues – what it means

RMB

The New York Times reports that China “on Tuesday sharply devalued the country’s currency, the renminbi, a move that could raise geopolitical tensions and weigh on growth elsewhere.”  Why?  What’s the big deal about changing the value of a currency by two percent?  Three reasons:

1. The value of the renminbi relative to the dollar is part of what determines the price of Chinese imports in the US.  A lower value of the renminbi implies cheaper Chinese imports, all other things equal.  That last phrase, all other things equal, is crucial: it means we assume that nothing else that affects the value of American products relative to Chinese substitutes is changing.  But we know that’s not true: Chinese wages are rising, fuel costs are falling, and a whole host of other things are not equal.  Thus, it’s pretty hard to tell how this will affect American manufacturers.  My hunch is that it won’t make much difference.

2. The devaluation is a signal of something bigger: the Chinese government will use every tool in the box to stimulate the economy.  They’ve loosened lending requirements on the stock market, prohibited short selling, lowered the central bank interest rate, and now devalued.  Look for increased government spending (perhaps tied ostensibly to the Winter Olympics) in the near future.

3. The biggest question is this: is China following Japan and other East Asian economies in experiencing high rates of growth for an extended period of time and then slowing down?  As Barry Eichengreen noted back in 2011, “Most strikingly, slowdowns come earlier in economies with undervalued currencies. One reason is that countries relying on undervalued exchange rates are more vulnerable to external shocks. Moreover, while currency undervaluation may work well as a mechanism for boosting growth in the early stages of development, when a country relies on shifting its labor force from agriculture to assembly-based manufacturing, it may work less well later, when growth becomes more innovation-intensive.”

A Chinese growth slowdown will affect countries from which it buys natural resources (think sub-Saharan Africa and Latin America) and increase the competition for manufacturers in Europe and North America.  Whether it hurts or helps those economies remains to be seen.


 

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