The China currency mystery By Scott Sumner

For the second time in six months, the world’s equity markets have been roiled by a tiny downward move in the Chinese currency. It seems unlikely that this is mere coincidence. And yet I’ve yet to see a convincing explanation of why the Chinese currency should influence global equity markets. Even worse, the explanations that are being offered are often totally wrong, not even consistent with basic economic theory. Consider this example:

China accelerated the devaluation of the yuan on Thursday, sending currencies across the region reeling and domestic stock markets tumbling, as investors feared the Asian giant was kicking off a virtual trade war against its competitors. . . . The People’s Bank of China again surprised markets by setting the official midpoint rate on the currency at 6.5646 yuan per dollar, the lowest since March 2011. That was 0.5 per cent weaker than the day before and the biggest daily drop since last August, when an abrupt near 2 per cent devaluation of the currency also roiled markets. The impact was immediate as regional currencies went into a tailspin. The Australian dollar, often used as a liquid proxy for the yuan, fell half a US cent in a blink. Shanghai stocks slid 7 per cent to trigger the halt in trading, a repeat performance of Monday’s sudden tumble. Japan’s Nikkei shed 1.8 per cent in sympathy. A sustained depreciation in the yuan puts pressure on other Asian countries to devalue their currencies to stay competitive with China’s massive export machine. It also makes commodities denominated in US dollars more expensive for Chinese buyers, which could hurt demand and thus further depress commodity prices in a vicious chain reaction.

There’s a lot here, and none of it makes any sense at all. Let’s start with what we do know.

1. The Chinese currency has been very strong in recent years, rising sharply in trade weighted terms. It is still very strong today. Nothing significant has happened to the value of the Chinese currency. Whatever problems the world economy has, a weak Chinese currency is most certainly not one of them.

2. The fact that commodities are priced in US dollars is completely meaningless, because commodity prices are not sticky. The US dollar price of commodities around the world would be precisely the same if they were priced in Swiss francs, Mexican pesos, or Zimbabwe dollars. It only matters which currency a product is priced in if the price of that product is sticky. Commodity prices are not sticky.

3. Whatever problems the world has, rising commodity prices for Chinese buyers is certainly not one of them. Commodity prices in China have been plunging sharply lower in recent years, as the yuan has gotten stronger and stronger. The last few days have seen Chinese commodity prices fall even lower.

4. A 1/2 cent fall in the Australian dollar is not a “tailspin.”

The claims in the article are not just slightly wrong, or debatable. They are almost 180 degrees off base. Almost describing the exact opposite of what has actually occurred. Here’s the value of the yuan in trade-weighted terms:

So then why did this Chinese action, as well as the previous tiny exchange rate adjustment a few months ago, seem to have such a big impact on markets?

I don’t know.

The global markets seem to have reacted as if they were being hit by a deflationary shock. Here’s my best guess, which is admittedly not very satisfying:

Something happened to reduce the perceived global Wicksellian equilibrium real interest rate. For instance, perhaps investors reduced their forecast of Chinese investment. Because central banks throughout the world target interest rates, a lower Wicksellian rate makes monetary policy tighter, as a side effect. Thus expected growth in global NGDP is lower.

The problem with my explanation is that it’s not clear why the Chinese action would lead investors to lower their estimate of the global Wicksellian rate. After all, the Chinese move would seem to be an expansionary monetary policy shift. On the other hand Chinese stocks fell more sharply than stocks in other places, suggesting that whatever shocks hit the market, hit China the hardest. And if you don’t trust the Chinese market (and there are good reasons not to trust it) then you must still account for the sharp fall in Hong Kong stocks.

Another possibility is that although the yuan is currently very strong, the recent action might have led investors to expect a sharp future devaluation. That would explain why there was a big reaction to such a small move in the exchange rate, but still wouldn’t explain the direction of the reaction. Why wouldn’t Chinese stocks rise? The US stock market rose when the US devalued in 1933 and in 2009. Dollar denominated debts? Perhaps, I don’t know how common those debts are in China. But the effect of a 0.5% devaluation against the dollar seems trivial, relative to a 7% fall in the Chinese market.

Another theory is that the devaluation signals worry about the economy within in the Chinese government. The markets are just waiting for “the other shoe to drop.” Maybe, but the previous exchange rate shock was not followed up by any notable news. Markets soon recovered. The consensus forecast for Chinese growth has not changed much in recent months, although it has dropped slightly. When will we see these dramatic events out of China?

To summarize, I think the most probable explanation has something to do with the Chinese action making monetary policy more contractionary throughout the world. That may be related to a perception of slower Chinese growth, which reduces the global Wicksellian interest rate. But we still have no explanation for why a tiny reduction in the value of the yuan, after years of strong appreciation, should have a big impact on either Chinese growth or global markets. As Napoleon might say:

A riddle, wrapped in a mystery, inside an enigma.

PS. Some commenters misunderstood a previous post I did on China. I do not support the government’s current policy stance; I think monetary policy in China is too contractionary.