China devaluing their currency

December 8th, 2008

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A couple of days ago, one of our readers, Zoo said that

Anyone read anything about China devaluing their currency? Just read a rumour that they are telling the USA they may embark on a currency devaluation within the next 14 days.

Four days ago, in this news report,

The [Chinese] central bank has shifted the central peg of its dollar band twice this week in a calculated move that suggests Beijing aims to offset the precipitous slide in Chinese manufacturing by trying to gain further export share abroad.

So far, devaluation is not a official government policy yet. But it has already sent shivers down the spine of many observers. To understand why, read on…

Firstly, many regard such a move by the Chinese as deflationary. If it is deflationary in the sense that Chinese-produced goods merely become cheaper, then it is not so much of a problem. After all, it is such kind of deflation (or rather, disinflation) that allows much of the Western world to enjoy low interest rates, low inflation and high asset prices over the past several years. But if it is deflationary because of trade, employment and currency flow reasons, then it will be a more serious problem.

One thing is clear- President-elect Obama will not be happy with such a Chinese move. Obama called China a “currency manipulator” during his election campaign, which if becomes an official view of his administration, will carry penalties under US trade laws. The US retaliation will most likely come in the form of tariffs on Chinese goods. This will have an eerie echo of the 1930 Smoot-Hawley Tariff Act in which the US

… raised U.S. tariffs on over 20,000 imported goods to record levels. In the United States 1,028 economists signed a petition against this legislation, and after it was passed, many countries retaliated with their own increased tariffs on U.S. goods, and American exports and imports plunged by more than half. In the opinion of some economists, the Smoot-Hawley Act was a catalyst for the severe reduction in U.S.-European trade from its high in 1929 to its depressed levels of 1932 that accompanied the start of the Great Depression.

It is said that the Smoot-Hawley Tariff Act helped to worsen the Great Depression. This time, it will be a severe reduction in trade between China and the US (plus the Europeans as well). A sudden freeze in global trade in the midst of a global financial crisis is hardly conducive for global cooperation that is necessary to fight this crisis.

This is just round one.

As the situation deteriorates, the Chinese government may respond with a ‘bugger it’ attitude and liquidate its hoard of US Treasuries. The outcome will be as we wrote before in China unwilling to hoard US dollars?what?s the implication?. The Chinese had threatened that in August 2007 (see China threatens economic nuclear bomb) and the US had almost gone along that path in April 2007 (see US shooting own foot with tariff on Chinese goods).

Such developments will be the economic equivalent of a nuclear war between two superpowers. The world will not benefit and it will be an economic disaster in the global scale. As in the 1930s, there will be trade blocs led by China, Europe and America, which can even develop into overlapping political and currency blocs. The US dollar is likely to crash (see What if the US fall into hyperinflation?) in the sense that it will no longer become the world’s reserve currency. Such an environment can lead to military conflicts as the chaos of 1930s arguably contributed to the Second World War of the 1940s.

The official Chinese government stand is currency stability. But beneath this serene official stand, it is likely that factions are vying for the Emperor’s favour. We can only hope that there are no miscalculations.

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