China playing a risky game with its currency

WASHINGTON — To understand China’s surprise currency devaluation, you need context.

China is engineering a major economic transformation — or, at least, trying. For years, it relied upon export-led growth and massive investments in housing, infrastructure (roads, rails, ports) and heavy industry (steel, glass, aluminum). This economic model now seems spent. World trade is weak. Overinvestment in housing, infrastructure and industry has left gluts. So China is switching its engine of growth to consumer spending on services and light manufacturing.

Whether this conversion succeeds or fails is a momentous story. A China that succeeds is likely to be more stable. The fate of the Communist Party also depends, to an unknowable extent, on the outcome.

What’s worrisome is that the unexpected devaluation suggests that China’s leadership is wary of the new strategy and is reverting to something more familiar. By weakening its currency — the renminbi (RMB), also called the yuan — China makes its exports cheaper on world markets. With sluggish global trade, China would stimulate its economy by grabbing export market share from other countries.

Naturally, this would displease China’s trade rivals — South Korea, Indonesia and others. Currency wars might ensue if they retaliated with their own competitive devaluations. The consequences for the U.S. economy would also be unhappy. The dollar is the world’s major reserve currency. As other currencies go down, the dollar goes up. American exports would become costlier, and imports into the United States would become cheaper. (Note: The dollar has already risen sharply against the euro and the yen.)

We don’t know whether any of this will happen. In their statements, the Chinese describe the RMB devaluation as a mostly technical change — blessed by the International Monetary Fund — designed to tie the currency’s value more to market forces than bureaucratic formulas. Many non-Chinese economists agree. So far, the devaluation is modest, about 3 percent through Friday. But if China continued the depreciation, the impact could be more meaningful.

“What’s roiled markets is [whether] this is the beginning of a trend, which could be quite disruptive,” says David Dollar, a former World Bank and U.S. Treasury Department economist now at the Brookings Institution. “If you get currency wars, you can imagine trade retaliation. That’s a bad world for new investment.”

China’s economy is clearly slowing. In July, exports were down 8 percent from a year earlier, writes economist Wang Tao of UBS, and a huge property surplus has “kept developers … from launching new projects.” Reflecting the housing slump and weaker infrastructure spending, production of steel, other metals and cement “either contracted or slowed further,” she reports.

Still, these are precisely the changes needed to push the economy toward consumer spending and away from reliance on heavy industry and exports. This transition, Dollar argues, is going better than is commonly realized. Consumption is growing faster than investment, and over the past year, household income is up 11 percent. By American and European standards, China’s economy is performing well, with annual growth between 6 percent and 7 percent.

But China’s leaders seem edgy — the recent stock-market debacle is another example. Perhaps they think most Chinese are conditioned to expect 10 percent annual growth rates (the 1980-2010 average). Or perhaps they fear restless youth. “They’re turning out 7 million college grads a year,” says Dollar. “It’s hard to grow good jobs for all of them.”

Whatever the cause, the main danger is that China will destabilize the global economy through excessive currency depreciation. To be fair, Chinese officials have said that they do not want a deep devaluation. If true, all of last week’s anxiety and upset will turn out to be much ado about nothing. But circumstances change, and governments sometimes do things they said they wouldn’t.

It’s hard to say where the RMB’s exchange rate should be. Some economists think it’s still undervalued, some think it’s overvalued; some think it’s about right. The United States is in an awkward position. It’s argued for years for greater reliance on “the market” — as opposed to government officials — to determine the exchange rate. The assumption then was that market forces would pull the RMB up. Now market forces are just as likely to push it down. The reason: Large outflows of money from China (nearly $500 billion over the last year, estimates UBS) mean massive selling of RMB.

But we do know that China still has a huge trade surplus and that RMB depreciation would make it bigger. The surplus in turn would reflect lost exports of other countries, whose growth would suffer accordingly. As Dollar warns, we would revert to a world of unsustainably large trade surpluses and deficits. The best course for China — and the world — is to continue moving away from its overdependence on trade and heavy investment.