China's Currency Devaluation Is Actually a Positive Thing

Following years of robust growth, China’s exports are now falling modestly and its export-related manufacturing is faltering. (Note that while China’s exports are declining, its imports are declining more rapidly, so for now GDP is growing faster than domestic demand.) Meanwhile, domestic consumption and services continue to grow rapidly, and households have accumulated significant purchasing power from several decades of rapid gains in personal income and extraordinarily high rates of personal saving. This will support sustained strong consumer spending. The government will take additional steps to stimulate consumption. The lifting of ceilings on yields on deposits in state-owned enterprise (SOE) banks and other financial reforms will increase personal income over time. More monetary and fiscal stimulus (primarily infrastructure spending) are expected as the government attempts to boost domestic demand to achieve GDP targets. Accordingly, China’s economic transition will continue to proceed rapidly, albeit with some bumps along the road.

China's Trade-Weighted Exchange Rate

1. China’s currency is overvalued relative to its shifting economic performance, and will be allowed to depreciate further. China’s sustained dramatic rise toward becoming Asia’s manufacturing hub and the world’s largest exporter of goods generated large demands for labor that pushed up wages in excess of productivity and resulted in sharp increases in unit labor costs.  At the same time, China’s currency has appreciated significantly on a trade-weighted basis. The combination of rising operating costs of production and a stronger currency have begun to dull China’s competitive edge.  The fall in exports increase the difficulty of achieving a smooth transition toward more reliance on consumption and services while maintaining a high rate of GDP growth.  Monetary and fiscal stimulus may directly boost domestic demand but such policies do not directly address China’s primary weakness, its declining exports. With productivity gains ebbing, a weaker currency is an effective mechanism to stabilize China’s exports. Under current conditions, if the currency does not depreciate, an “internal depreciation” can be expected in the form of lower real wages.

2. Economic indicators of China’s export and manufacturing sector have been decidedly poor, while indicators of China’s consumers have been decidedly more upbeat. China’s PMI survey index indicates declining manufacturing activity. While not a surprise, it is a disappointment to markets that had come to rely on China’s booming manufacturing. However, indicators of China’s consumer and services sectors remain healthy. Amid China’s economic transition, it is important to put the data and survey results from different sectors in their proper perspective. Most likely, nervousness will prevail until skeptics are convinced that China will not incur a hard landing, and that may take a while.

3. As a large and open economy, with exports and imports sizeable portions of GDP, China’s currency plays an important role in influencing its international trade and capital flows. In the years before mid-2005, the Chinese yuan was pegged to the US dollar at a low exchange rate as part of China’s policies to stimulate exports. Since then, its value versus the dollar has been closely managed by the Peoples Bank of China (PBoC). Through year-end 2014, the yuan was allowed to appreciate versus the dollar (from 8.3 yuan/US dollar to 6.15 yuan/US dollar). In August 2015, the PBoC announced abruptly a minor depreciation to 6.33, and since then it has depreciated to 6.6 yuan/US dollar. With the US dollar appreciating versus the euro and yen, and by even more versus some emerging nations that are significant trading partners with China, the yuan has appreciated significantly on a trade-weighted basis; since mid-2011 it is up by approximately 28%. At the same time, exports have flattened, private business investment spending and foreign direct investment in China have slowed, and some modest financial reforms that have begun to liberalize restraints on cross-border flows have allowed net capital outflows from China. These economic and financial trends suggest that China’s currency is overvalued.

4. An appreciation of the yuan would improve China’s relative costs of production versus its trading partners, but all of China’s trading partners would be better off if a depreciation of the yuan helps to stabilize China’s tradeable goods sector and improve its economy.  It is fully understandable that skeptics believe such policy actions reflect desperate actions by Chinese leaders to avoid undesirable economic weakness or that they may undercut the effectiveness of foreign manufacturers that are already burdened by a host of economic challenges. However, not responding to current conditions would be a costly mistake. As China transitions its economy, a moderate currency depreciation, under the circumstances, seems to be a reasonable and positive economic adjustment. It may take time, but eventually markets will sort out these adjustments and come to realize that its initial responses were excessively negative.

Mr. Levy is chief economist, Americas and Asia at Berenberg Capital Markets LLC, and a member of the Shadow Open Market Committee at the Manhattan Institute.

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