'Is China's Devaluation a Game Changer'

If you can't get enough on China, here's more from Cecchetti & Schoenholtz:

Is China's devaluation a game changer?: Since 1978, China has engaged in an unprecedented and wildly successful experiment, moving gradually from a command economy to one based on markets; in small steps transforming a system where administrators controlled the goods that were produced to one where prices allocate resources. There were surely miscalculations along the way. But, even big blunders could largely be concealed. Until now!

What has changed in recent months? The day has come for China to become more closely integrated into the global financial system, and this has a number of implications. The most important is that as prices and quantities of financial assets (rather than goods) are determined in markets, bureaucrats lose a great deal of control. But, as recent events very clearly demonstrate, Chinese authorities are reluctant to let go.

Last August, we posted our most popular blog piece to date: China’s Capital Controls and the Exchange Rate Regime. In it, we explained how capital controls make it possible for China to maintain a fixed exchange rate while policymakers could adjust interest rates to stabilize their domestic economy. We also highlighted how these same capital controls are incompatible with the objectives of making Shanghai a global financial center and the renminbi (RMB) a leading international currency. Given the risks inherent in freeing cross-border capital flows, we concluded that the process of financial liberalization (both domestically and externally) would remain gradual. Yet, having seen China develop in unprecedented ways in the past, we have been watching to see if China could also alter conventional paradigms of finance and monetary policy. Could China do what no one else has done?

Well, it turns out that the “impossible trinity” or “trilemma” – which compels policymakers to choose only two of three from among free capital flows, discretionary monetary policy, and a fixed exchange rate – may be more like a physical law than nearly any economic principle we know. And policymakers in China look to be quite unhappy about the constraints this is creating. (For more on the impossible trinity, see here and here.)

Here’s what has happened. ...

After a detailed discussion of the issue, they conclude with:

... For a country that wishes its currency to join the ranks of the reserve currencies, the reputational costs of a modest devaluation would seem to sharply exceed any possible economic benefits. Ultimately, a true reserve currency is one that is reliably available to provide liquidity insurance internationally even in tough times. As our friend and colleague William Silber notes in his book on the financial upheavals that accompanied World War I, this is one reason staying on the gold standard propelled the U.S. dollar to the reserve status it still maintains today. Imagine, instead, that American officials in 1914 had chosen to leave the gold standard in order to achieve a depreciation of 3%!

The Chinese authorities’ newly demonstrated lack of confidence in financial markets – whether the RMB or equities – undermines their promise to increase reliance on market forces. So, while the IMF welcomed the RMB “regime shift,” no one anticipates a floating currency regime anytime soon. Similarly, the government’s clumsy equity market interventions have encouraged investors to push back the expected timing for including China’s domestic equities in key international benchmarks, and at least temporarily dampened hopes for Shanghai to become an international financial center. But, without a system in which foreign exchange and equity prices are market determined, global integration of China’s financial system as well as reserve status for its currency will remain beyond the country’s grasp.

The bottom line: Today, China is the world’s largest economy on a purchasing-power parity basis. And it still has the second largest equity market (by trading volume and capitalization). If and when market forces clearly become the dominant factor in currency and equity price determination, the RMB and China’s financial assets will gain sharply in global importance, as will China’s domestic financial markets. Yet, by this standard, China’s 3% devaluation is no game changer. If anything, the recent actions by the government have delayed its achievement of these aims.