Wars are funny the way they bring people together. I wouldn’t exist if not for Vietnam. It was 1966. My father was studying at UCONN in Storrs, Connecticut and he had discovered his draft number was coming up. Rather than risk coming home in an Army-issued body bag, he did as many boys did back then and rushed out to join the Air Force. To this day, basic trainees are shipped to Lackland Air Force Base for that grueling six-week introduction to serving Uncle Sam. And that’s where he met my mom, a girl from South Texas who commuted to the big city where she was starting a 37-year career as a civil servant.
Wars also rip things apart; never does a true ‘victor’ emerge, and many lives are ruined. That was certainly the case in World War II, which also claimed the economic casualty of the British Pound Sterling. And that brings us to why the Chinese greeting “Nihao,” elicits all manner of drama in my home. Such is the reaction of my four children when the time comes twice a week, every week, to sit down and endure their Mandarin lessons.
There is no conspiracy afoot but rather prudent parental planning. History has a tendency to rhyme, we’ve all been told, even if it doesn’t exactly repeat verbatim. If the Chinese do indeed have their eye on their currency reigning supreme once again, as was last the case during the Liang Dynasty in the 5th Century AD, better to be prepared rather than unprepared for a potential military conflict such as the one which preceded the British pound’s decline and King Dollar’s ascent. Let’s just say that the knowledge that my four children will be fluent in Chinese helps me sleep at night. We know from history that the State Department places a premium on language skills during times of war. Call it the mother of all insurance policies.
Debating Chinese politicians’ motivation for the August 10th devaluation of the yuan, the first such move since 1994, is de rigueur among financial market players and economists alike. Questions abound. Is this move simply a defensive maneuver to prevent their currency from continuing to appreciate vis-à-vis the dollar? There’s no way the past five years’ 30-percent inflation-adjusted broad effective exchange rate appreciation has been easy to stomach for the Chinese, despite the yuan’s undervalued starting point.
No doubt, a weaker yuan will benefit China’s ailing, over-capacitated manufacturing sector by making its exported goods more affordable to its trading partners. But a three-percent devaluation in the currency won’t even begin to nudge the needle on the world trade speedometer. The hobbled Chinese export machine needs a whole heck of a lot more than a one-off adjustment to get back up and running. And that’s assuming the rest of the world is capable of absorbing higher imports, a steep assumption if there ever was one.
Some theorize that the devaluation is the first baby step towards abandoning the link to the dollar on the road to eventual independence or perhaps an Asian currency block. While the Chinese policymakers have not been coy about their intentions to segue to a market-based pricing mechanism for their currency, once again, the magnitude of the devaluation is insufficient to conclude this qualifies as a base case. That said, it has been eye-opening to witness the applause of the International Monetary Fund, and even our own Treasure Department. In the IMF’s words, the yuan reforms could bring the currency “close” to a full floating rate status.
Of course, the road to floating-rate nirvana is not paved with gilded ease. Some estimates put the annual level of capital flight at $800 billion. Any further devaluation will push more capital out the red-lacquered door. Moreover, Chinese companies are saddled with $1.2 trillion in dollar-denominated debt. The cheaper the yuan, the more expensive the debt to service. As for my former employer, the Fed is loath to withstand any kind of dramatic devaluation. The strong dollar is already acting as an anvil on US multinationals, not that currencies are technically an operative that falls under the Fed’s directive.
What is formally mandated, however, is that the Fed maintain price stability. It’s difficult to succeed in doing so when the Chinese are importing lower prices into the US faster that the domestic economy can pressure prices upwards. The deflationary Chinese cards were stacked against the Fed even before the early August surprise devaluation. The increasingly rapid pace of Chinese import price declines can only be exacerbated by a weaker yuan. Consider today’s starting point: the currency’s 2.3-percent annualized slide over the past three months is the deepest in two years. Interest rate strategists at Morgan Stanley figure that every subsequent two-percent depreciation in the yuan results in a 0.5-.10 percentage point pass through to lower core consumer prices here in the US.
Central bankers worth their salt will tell you that lags matter. We know there’s little chance that the yuan depreciation will filter through to consumer prices before the Fed convenes on September 16th and 17th to decide if they will lift interest rates for the first time in nine years. In true economist speak – on the other hand, with their inherent appreciation of lagged effects in hand, policymakers will have full knowledge that deflationary pressures are building in the pipeline. So will they hike? Or will they heed to the risk of a policy mistake? (Spoiler alert: they have yet to blink at the risk of the latter).
For now, I’m sticking with my friend, Leland Miller’s take on the situation. Lee is the Chairman and CEO of the China Beige Book (CBB), the ultimate weapon to combat the sometimes questionable reliability being distributed by Chinese policymakers labeled as “economic data.” (If you must know, Lee doesn’t think things in China are near as dire as the media and most doomsayers purport).
In Lee’s view, China has not just launched an all-out currency war. The move to devalue is better described as “tweaking around the edges.” That said, it also, “raises global uncertainty, annoys the US Congress, and is part of a silly cat-and-mouse routine with the IMF. But China knows how to take decisive steps, and this isn’t one.”
Perhaps it’s not so much what China has done that concerns me. Rather it’s how the rest of the economically stressed world reacts, especially as it pertains to emerging markets that are directly affected. My favorite anecdote that best captures the damage wrought by Chinese hyperactive industriousness is that between 2011 and 2013, the Chinese produced more cement than did the US in the entire 20th century. At some point, some move by China could sufficiently anger its already testy trading partners who are exhausted by the deflationary effects of China’s never ending flooding of the world’s commodities markets.
Lee nods to this as a potential risk: “What China’s trading partners do now is a harder question. In light of their own behavior, they are not justified in treating this as aggressive on China’s part. But they might anyway.”
Which brings us back to the gnashing of the teeth by my offspring when the ever patient Ms. Li walks through the door to school my unruly brood in the national language of the People’s Republic of China. Navigating the aftermath of one of the most extraordinary build-ups of debt in the history of mankind could prove to be too tall of an order for Chinese policymakers, even ever-equipped as they always are with strong-armed maneuvers. If the Chinese do intend to introduce a full blown currency regime shift, if this is not a small chess move, if this is an orchestrated first step towards assuming reserve currency status, well then that could be a game changer, not just for the global economy and financial markets, but potentially for the balance of nations as we know it today.
It’s been five years since China overtook Japan as the world’s second largest economy, exactly how long Mandarin has been taught in my home. Along the way, tensions between Japan and China have been building as the larger of the two nations needles the other by engaging in inflammatory tactics such as building airstrips in the middle of the disputed South China Sea. The alarming thing about superpower squabbles is they could spill out onto the world stage with disastrous results.
Most acknowledge that there’s no turning back from a world that’s gone global. The alternative, back-tracking and economic isolationism, introduces the potential for conflict. Either way – continued economic integration or brewing conflict if the globe looks inward – my kids are reluctantly but effectively covered. The dodge has been drafted.