Could China go ‘nuclear’ and devalue its currency to boost ailing recovery?

Devaluation is a common temptation for major trading nations such as China despite the risk of starting currency wars and angering trading partners
A recent report argues that devaluing the yuan could bring major benefits and spur Beijing and others to experiment further

Anthony Rowley

Published: 3:45pm, 29 Jul 2023

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Could China reach for what is sometimes termed a “dirty” weapon as it faces an increasingly hostile external environment? This does not mean using the literal “nuclear option” to counter security threats but instead resorting to a major yuan devaluation.

A recently published report by the Institute of International Finance (IIF) argues that currency devaluation could bring major economic benefits and spur China and others in and beyond Asia to experiment with this controversial weapon at a time of economic warfare.

While the economic logic behind such a strategy might seem sound, it could set off a series of currency wars among the highly trade-competitive nations of the region, adding to existing economic stresses created by protectionism and supply chain fragmentation. Even so, all is fair in love and war.

Currency devaluation is always a temptation for any major trading nation faced with stagnating external and domestic demand coupled with deflation. This is much more so in the case of a major power such as China, which is the world’s second-biggest economy and largest exporting nation.

Critically, devaluation is also seen by some as a possible way to escape from the kind of liquidity trap China is widely perceived to be caught in now. In this trap, domestic demand fails to respond to monetary or fiscal stimulus and simply raises savings rates rather than consumption.

However, there is a view among economists that currency devaluation is a double-edged sword. It can boost export volumes and values but also create upward pressure on import costs and inflation, thereby negating part of the benefits.

This can earn the devaluing economy disapproval or even ire from its international trading partners without the offsetting benefit of boosting growth. Some observers believe China would face such a danger if it resorted to devaluation.

Jesper Koll, former chief economist for US investment banks JPMorgan Japan and Merrill Lynch Japan Securities, has suggested that China could opt to devalue the yuan by 20 per cent to 30 per cent in 2023 as it struggles against slowing domestic demand and a more hostile external environment.

Now, though, Koll says that while “the economic arguments for devaluation are obvious, China is first and foremost a political animal”. Devaluation, he suggested to me, “risks the wrath of China’s strategic partners in Asia and the Global South, many of whom compete head-to-head in key products”.

Devaluing the yuan is a controversial tactic that holds great promise for addressing some of China’s economic issues but also carries risks for relations with its trading partners. Photo: DPA

Koll added that yuan devaluation at this time would “not exactly build confidence that a China-based global reserve currency is better than the US dollar”. There is also the argument that a significant yuan devaluation could create the impression of a currency war with a strongly depreciated Japanese yen.

Meanwhile, the IIF report offers a vigorous defence and perhaps political cover for currency devaluation. Deploying the devaluation option could take on a wider appeal in and beyond Asia if global economic conditions deteriorate further in the short to medium term.

The report, authored by IIF chief economist Robin Brooks and others, goes so far as to suggest that “devaluations are an underused policy tool to fix moribund growth”. The topic is “widely misunderstood” in policy circles, it argues, and as a result is not considered to be a viable economic option.

One primary reason is that because many exporting countries employ the practice of invoicing trade partners in US dollars rather than in their own currencies, it is wrongly assumed that the benefit of devaluing those currencies is automatically cancelled out. The IIF report takes issue with this after studying the experiences of advanced and emerging economies since 1990.

In most cases, there is a clear increase in export volume growth, which rises with the scale of devaluation. The effect becomes material two years after the devaluation and lasts for many years as imports are compressed and current account deficits narrow. The most persistent devaluation episodes see GDP growth outperform after three years.

China’s balance of payments current account swings from surplus to deficit, and, in the first quarter of 2023, the surplus was US$81.5 billion compared with about US$103 billion in the previous quarter. It has moved between a deficit of US$34 billion in March 2020 and a high of US$144 billion in September 2022, according to the State Administration of Foreign Exchange.

China’s exports are facing problems now, though. Last month, exports fell at their fastest pace since the start of the Covid-19 pandemic three years ago, with an ailing global economy putting mounting pressure on Chinese policymakers to come up with fresh stimulus measures. Capital inflows into China in the shape of business investment are also under pressure.

These developments could increase the appeal to policymakers in Beijing of a yuan devaluation. However, the impact of any such move would need to be weighed carefully against the potential negative effect on China’s main trading and investment partners, especially in Asia.

The IIF report acknowledges that there are some downsides to currency devaluation, and those can be painful. They imply meaningful disruption, especially when hard currency debt plays a big role. However, it says that “as asymmetric shocks – from climate change to heightened geopolitical risk – multiply, we think the policy consensus needs to shift back to seeing exchange rate devaluations as part of the solution and not a problem to be avoided”.

Anthony Rowley is a veteran journalist specialising in Asian economic and financial affairs