Casting the first stone at China’s currency devaluation

Yesterday’s surprise 2 percent Chinese currency devaluation is bound to raise charges in Congress that China is a serial currency manipulator. Never mind the context in which that devaluation occurred and the sharp appreciation of the Chinese currency that preceded it. Never mind, as well, that other economies — including the United States, Europe and Japan — have all responded in recent years to a weakening in their economies with an unprecedented degree of monetary policy easing. And that easing has had the effect of weakening their currencies by a large multiple of China’s 2 percent devaluation.

{mosads}The People’s Bank of China’s decision to weaken the currency has occurred against the backdrop of a marked slowing in the Chinese economy, including its all-important export sector. It has also occurred in reaction to a dramatic bursting of its equity market bubble. That bursting has seen around $3 trillion wiped out in equity valuations, which has seriously dented investor and household confidence in the Chinese economy.

It is also important to recognize that the most recent Chinese devaluation was preceded by a very sharp real appreciation of its currency. Indeed, over the past year, the Chinese currency appreciated by 15 percent in real effective terms, while since 2008 it appreciated by around 50 percent. That sharp currency appreciation has contributed to a marked reduction in the Chinese external current account surplus from around 10 percent of gross domestic product (GDP) in 2008 to 2 percent of GDP in 2014. It has also induced the International Monetary Fund to consider that the Chinese currency is no longer undervalued.

Before Congress starts casting stones at China’s recent currency move, it might wish to reflect on how the Federal Reserve responded to the bursting of the U.S. housing market bubble and to the subsequent Great Economic Recession. In addition to drastically cutting interest rates to the zero bound, between 2008 and 2014 the Federal Reserve engaged in a massive amount of quantitative easing. That easing saw the Fed’s balance sheet increase in size from $800 billion in 2008 to around $4.5 trillion at present. That easing also contributed to a sharp weakening in the dollar that drew charges from emerging market countries that the United States was engaged in a currency war.

More recently, both Japan and Europe also responded to economic weakness with an unprecedented degree of monetary policy loosening that contributed to very sharp depreciations in their currencies. Indeed, since early 2013, when the Bank of Japan launched a quantitative easing program that made that in the U.S. pale, the Japanese yen has depreciated in real effective terms by more than 30 percent, tasking it to its lowest level since the 1970s. Similarly, since the third quarter of 2014, when the European Central Bank announced that it too would engage in aggressive quantitative easing to ward of deflation, the euro has depreciated by around 20 percent.

This is all not to say that the Chinese currency move does not have significance. Rather, it is to say that the Chinese move is symptomatic of a very much deeper flaw in the global economy that needs a thoughtful response. The fundamental problem is that there seem to be no internationally agreed rules in place that inhibit countries from taking action to stimulate their economies by policies that, intentionally or not, substantially weaken their currencies. This runs the risk that we could be drifting toward a world of currency wars that could seriously undermine the global trading system to everyone’s disadvantage.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.