Is China Preparing for Currency War?

China has entered the global monetary-easing fray, along with more than a dozen other economies, after its central bank surprised investors by cutting reserve requirements 50 basis points to spur lending and combat deflation. But Beijing may be raring for an even bigger and more perilous fight — in the currency markets.

At the same time, something else is afoot in Beijing could have even greater global impact. The central bank is cooking up measures to widen the band in which its currency trades. People’s Bank of China officials say it’s about limiting volatility as capital zooms in and out of the economy. Let’s call it what it really is: the first step toward yuan depreciation and currency war.

As China grapples with its slowest growth in 24 years, President Xi Jinping is under pressure to stimulate the economy. Yet that would run afoul of his pledges to curb runaway debt and credit (the latter jumped about $20 trillion from 2009 to 2014). What better way to gin up growth without adding to China’s bubbles than by sharply weakening the exchange rate? A cheaper yuan would boost exports and buy Xi more time to recalibrate growth engines away from excessive investment and debt. “The real economy desperately needs a weaker yuan,” says economist Diana Choyleva of Lombard Street Research.

The question is, does the rest of the world? Any significant drop in the yuan would prompt Japan to unleash another quantitative-easing blitz. The same goes for South Korea, whose exports are already hurting. Singapore might feel compelled to expand upon last week’s move to weaken its dollar. Before long, officials in Bangkok, Hanoi, Jakarta, Manila, Taipei and even Latin America might act to protect their economies’ competitiveness.

There’s obvious danger in so many economies engaging in this race to the bottom. It will create unprecedented levels of volatility in markets and set in motion flows of hot money that overwhelm developing economies, inflating asset bubbles and pushing down bond rates irrationally low. Consider that Germany’s 10-year debt yields briefly fell below Japan’s (they’re both now in the 0.35 percent to 0.36 percent range). In a world in which the Bank of Japan, the European Central Bank and the Federal Reserve are running competing QE programs, the task of pricing risk can get mighty fuzzy.

Full article: Is China Preparing for Currency War? (Bloomberg)

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