By Ambrose Evans-Pritchard
China has abandoned a solemn pledge to keep its exchange rate stable and is carrying out a systematic devaluation of the yuan, sending a powerful deflationary impulse through a global economy already caught in a 1930s trap.
The country’s currency basket has been sliding at an annual pace of 12pc since the start of the year. This has picked up sharply since the Brexit vote, suggesting that the People’s Bank (PBOC) may be taking advantage of the distraction to push through a sharper devaluation.
“This makes a mockery of the PBOC’s suggestion that its policy is to keep the currency’s value stable,” said Mark Williams, chief China economist at Capital Economics. “Markets will not take PBOC policy statements at face value in the future.”
Mr Williams said it is unclear whether Beijing intended to deceive investors all along when it gave categorical assurances earlier this year, or whether it is feeding on events.
Either way the markets have stopped believing what they are told, storing serious trouble for the authorities should there be another surge in capital flight later this year, as widely expected.
“When it comes, the PBOC will find itself sorely lacking in credibility. It may have to intervene on a large scale to maintain control,” he said.
Factory gate prices within China are falling at a rate of 2.9pc, further amplifying the deflationary impact. Analysts fear that Beijing is engaged is an undeclared policy of beggar-thy-neighbour mercantilism, trying to avert an industrial crisis at home by exporting its overcapacity in steel, shipbuilding, chemicals, plastics, paper, glass, and even solar panels, to the rest for the world.
“When you have a relatively closed capital account like China, it means that any currency move like this is a policy decision,” said Hans Redeker, currency chief at Morgan Stanley.
“They seem to be overriding their own model and letting the remnimbi (yuan) fall to improve competitiveness. They are in the same sort of deflationary syndrome as Japan in the 1990 but on a much bigger scale. The global economy is in no position to absorb this.”
Import prices in Japan have collapsed by 20pc over the last year, 5.5pc in Germany, and 5pc in the US, despite the recovery oil prices.
Mr Redeker said China’s attempt to export its problems though devaluation is a key reason why inflation expectations are crashing to record lows across the developed world.
This in turn is driving bond yields to historic lows almost daily, with 10-year borrowing costs down to -0.58pc in Switzerland, -0.28pc in Japan, -0.16pc in Germany, 0.14pc in France, 0.78pc in Britain, and 1.4pc in the US.
The actions of Chinese elites are mystifying. Premier Li Keqiang gave a cast-iron promise in January that the yuan would remain “basically stable” in weighted terms. “China has no intention of stimulating exports through competitive currency devaluation,” he said.
Top officials went on a worldwide campaign to broadcast the same message, reassuring investors and Western leaders in Davos that China would play the good global citizen. This helped to stabilise the yuan after a spasm of capital flight and $700bn of reserve depletion. It appears that premier Li – a reformer - has been sidelined in an internal power struggle.
Beijing is fully aware the latest blast of loan-driven growth is becoming dangerous and gaining ever-less traction as credit efficiency declines. The temptation to exploit the exchange rate to keep growth going may have become irresistible.
The latest twist comes from the foreign reserves data, which suggest that China may have begun to intervene actively in the markets to drive down the yuan. This would have grave repercussions. Provisional figures imply that the PBOC purchased a net $34bn of foreign bonds in June, once valuation distortions are stripped out.
Mr Williams said it is too early to tell whether this was active buying. “If they are intervening it would set off a bomb in relation with the US, especially in the run-up to the US elections,” he said.
The White House has become neuralgic about the strength of the US dollar after a 20pc surge since mid-2014, one of the most dramatic spikes of the post-War era. US officials read the riot act at the G20 summit in Shanghai in February, warning Japan and Europe that use of negative interest rates as a stealth tool to drive down exchanges would not be tolerated.
The clash with China is even more loaded with emotion. Republican candidate Donald Trump has accused China of “raping” the US with unfair trade policies, and the Democrats’ Hillary Clinton is no slouch in berating Beijing either.
China is now in a very difficult position. Economists at Nomura say the yuan is 6pc overvalued, the result of an relentless rise when it was still coupled to the dollar, and due to the internal effects of rising labour costs and slowing productivity growth.
Yet a fragile world economy cannot cope with a falling yuan. China’s fixed asset investment has been running at $5 trillion a year, as much as in North America and Europe combined. The country is hostage to an investment-led growth model that was not reformed in time, and relies too heavily on exports.
The steel saga of the last year offers a vivid illustration of how this model distorts the global economy. China’s share of world steel output has risen from 10pc to 50pc over the last decade. It has built up 400m tonnes of excess capacity, twice the size of the entire EU steel industry.
CREDIT: WORLD STEEL ASSOCIATION
The surplus has flooded Europe, encouraged by export subsidies, tax breaks, and cheap state credit. Even where the volumes admitted have been modest, the marginal effect has upset the market and led to a price slide. Episodes like this help to explain why global deflation is becoming systemic.
China’s growth rate has picked up to 4pc to 4.5pc following the stimulus measures of the last year, based on a proxy gauge created by Capital Economics. There is enough juice in the pipeline to keep the economy rolling along for a few more months: before the latest property boomlet fizzles.
The closer we move to this tipping point, the more tense it will become, for China and for the world.