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July 14, 2015

Forget Stocks, Yuan Is China's Real Problem

By Lior Alkalay, INO

In the past few weeks, and especially this last one, equity investors watched in horror as China's stock market began to disintegrate. More than $3 trillion in value disappeared in what seems like the blink of an eye. Over the same period, the FX market has been preoccupied with the unfolding events in Greece. Many investors believe that, while Greece is very relevant to the FX market, China's problem pertain only to a bubbly stock market. If that's what you believe, too, you thought wrong! China's stock crash is a mere side effect of the country's real problem – the Chinese Yuan.

China's Ambition for the Yuan

The Yuan has always been a critical tool for Chinese policy makers. During the 1990s, China essentially sacrificed the Yuan in favor of growth as it aspired to become the world's factory. That thanks in large part was to a cheap labor force. Cheap labor is essentially only possible with an undervalued currency. The Chinese government succeeded in its endeavor. China rose to prominence, moving swiftly from a somewhat marginal economy to the world's second largest economy. There is no other way to describe it except as a phenomenal economic achievement and one skilfully executed.



Now, Chinese leaders have reached their next resolution and are set to take the first step. Once again, the government’s resolve relates to the Yuan. In order to avert a Japanese style of rise and decline, China's government wants to do things differently. The government recognizes that it must turn the Yuan into a reserve currency, one that matches the dollar. This will allow China to turn into a more sustainable credit-driven economic model, à la the United States.

The Chinese government came to a great, earth-shattering realization. That realization is simply this: The reason the US can weather even the most challenging economic crisis is because the dollar is the world’s reserve currency. The greenback is so critical to global settlements that the US government can essentially borrow its way out of trouble. Of course, unlike pretty much every other country.

This intrigues Beijing; a more stable economy means a more stable government. That means the current Chinese government could secure the future of the party and thus its hold on the country. Making the Chinese Yuan a reserve currency is fast becoming a priority in Beijing. In that quest, China has made an 180-degree turn and decided to compromise growth and allow/push the Yuan higher.

Things Don't Go as Planned

China's ambition to become the world's factory and the consequent rise to prominence went remarkably smooth. Not so this time around, though. China can simply not sustain the current of the Yuan appreciation and here is why:

While the Yuan has continued to appreciate, wages in China have been rising as well. This resulted in the old double whammy for Chinese exporters. Since exporters earn in dollars their costs have been rising, first because of wages and then because of the rise in the Yuan exchange rate.

Chart courtesy of Tradingeconomics.com

And after China's long, long dependence on exports for growth, this dependency can't just be waved off for a new model. The proof is in the pudding, as they say. Data shows the Chinese economy keeps slowing, inflation is quickly plunging and PMI readings are taking a nose dive. China's rate cuts don't seem to make any difference to growth or to inflation.

Chart courtesy of Tradingeconomics.com

Yuan Has to Go Down

Eventually, the Chinese government will have no other choice. To soften the pressure on its economy and revive its inflation, it will be forced to resort to its old tool. Yep, once again, Beijing will have to sacrifice the Yuan in exchange for growth. The Yuan, at some point, may return to rise. At the moment, though, given an economy long "addicted" to a weak Yuan, it is going to be a tough addiction to break.

Courtesy Lior Alkalay for INO.com

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters. © EconMatters All Rights Reserved | Facebook | Twitter | Free Email | Kindle


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