On August 11 China said that, as it took a step toward a more freely traded currency, it was allowing the RMB to depreciate by roughly 2% in one day. Skeptics laughed at this, suggesting that the move had nothing to do with the free market and everything to do with a desire to dramatically lower its exchange rate in order to boost exports, possibly igniting a currency war. Yet, roughly three weeks later, the RMB trades at only 2.7% below its value before the so-called “devaluation.” Even the most ardent China haters would have a hard time saying 2.7% is a major devaluation, particularly since the Euro and Yen have each depreciated more than 10% against the US dollar over the last 12 months.
The fact is there are many reasons why a dramatically lower currency doesn’t make sense for China. Below we briefly describe the main reasons.
Exports aren’t as important as they used to be
Exports accounted for 23 percent of the economy last year, compared with a peak of 36 percent in 2006. China knows it has to get its growth from other areas.
Capital outflows are more important
Capital outflows are natural when an economy slows. That is particularly true in an economy in which capital controls have prevented people from diversifying their assets in the past. Capital outflows also drain capital that an economy needs to grow. China has been trying to reign in capital outflows all year for this reason. A lower currency will most definitely lead to more capital outflows. It would be unwise for China to choose exports over capital as it would be a zero sum game in the end.
China doesn’t need devaluation to be competitive
China’s share in global exports has increased to 15% in 2015 versus 8.7 percent in January 2010, despite the inflation-adjusted exchange rate for the RMB appreciating by 33% against its major trading partners. In comparison, a majority of emerging markets including Singapore, Brazil, Thailand, Hungary and Indonesia lost ground.
The problem is weak demand, not high prices
China’s export woes are a result of economic weakness around the world, particularly Europe, Japan, and the US. As was mentioned above, China is already gaining market share. To lower prices so as to gain more market share in a shrinking market does not sound like a promising approach.
China knows others will follow suit
Most other currencies have already weakened against the US dollar over the past 12 months. If China were to devalue significantly other countries, particularly other low-cost, emerging markets, would likely do the same, resulting in a genuine currency war. China likely realizes that this possibility, combined with the all of the other reasons above, make it unwise to pursue a significantly lower exchange rate.