The only thing China had to wait for was the official inclusion into the International Monetary Fund’s (IMF) reserve currency basket. Now it can devalue its currency as it pleases—and it may not even have a choice.
“A devaluation could be as much as 20 percent against the U.S. dollar because in real effective exchange rate terms the yuan is about 15 percent overvalued at the moment,” says Diana Choyleva, chief economist at Lombard Street Research.
The Chinese currency has gained 15 percent against other major currencies since the middle of last year, according to an analysis by Westpac Strategy Group.
On cue, China set the yuan at 6.414 to the U.S. dollar on Wednesday, Dec. 9, its weakest level since August 2011 and down 3.4 percent since the mini-devaluation in August.
Macquarie analysts also believe Beijing now likely won’t “risk their credibility by devaluing the yuan sharply after that.”
But while there is clarity as to how (gradual) and how much (15–20 percent) China will devalue, there is still confusion as to why they have to do it.
Market observers usually cite exports as the major reason for a cheaper currency. In theory, prices for Chinese goods would become cheaper on international markets so volumes would pick up.
In practice, this rarely works, as imports become more expensive, as China is a big importer too.
In addition, trade just doesn’t contribute that much to the Chinese economy anymore.
“They were at the peak which was just a few years ago. Their net exports were 8 percent of GDP. Now it’s just a couple of percent of GDP,” says Richard Vague, author of “The Next Economic Disaster.”
Exports make up even less of GDP growth. Consumption and investment make up most of Chinese GDP growth.
To fire up consumption and not let investment drop off a cliff, China has lowered interest rates six times this year.
“You have had six interest rate cuts in the past year. And yet the economy is meant to do fine at 7 percent or so. And that doesn’t tally with the reality on ground—the economy is growing much slower,” says Fraser Howie, author of “Red Capitalism.”
It’s the combination of low growth and easy money that puts pressure on the currency. Because the regime created a debt bubble of epic proportions and investors now realize they won’t get the promised returns, capital is flowing out of the country at a record pace.
Until the imbalances are fixed and China takes its losses, and stops the easy money policies, outflows will continue and the regime will face continued pressure to devalue.
So far, the regime has managed the decline by selling foreign exchange reserves. Purely from an economic point of view and disregarding the IMF power politics, it would be better to correct the imbalances with a one-off devaluation.
History teaches us that countries spend foreign exchange reserves to defend their currencies and most have to devalue in spite of it. The Russian ruble is a good example from the recent past; the Asian currencies and the British pound are good ones from the 1990s.
So if you can’t have your cake and eat it too, why not just keep it?