Macroscope | Why a currency war is the last thing China needs

Currency wars are likely to remain a fixture of the world’s economic backdrop, especially if global growth remains lacklustre. Game Theory shows that even rational governments have strong incentives to engage in currency wars, even though they are negative sum games with a lose-lose outcome when everyone is involved. Some analysts are predicting a 10 per cent devaluation of the yuan in the coming year, which is an important tail risk given weakness in the euro and yen. Devaluation would not be the best option for China. On balance, Beijing’s rational policy response would be for it to resist joining a currency war. The recent change in the yuan’s daily fixing regime is not a harbinger for a devaluation. If the global economy fails to regain healthier growth, a currency war will likely prevail because in a world of feeble growth and insufficient policy levers to boost aggregate demand, currency devaluation can be a useful tool to stimulate growth. But in competitive devaluation, one country gains at the expense of the other. The resultant increase in foreign exchange (FX) volatility will raise the cost of international trade and investment, leading to contraction in capital flows and global growth and, thus, a lose-lose outcome. So countries should avoid such an outcome, right? Not necessarily. To maintain their strategic positioning, even rational governments would have a strong incentive to devalue, and the only stable equilibrium would be one in which everyone devalues. The more intense the competitive devaluation, the higher is the cost in terms of hedging and trade contraction and slower economic growth. It is a negative sum game. So why do governments still engage in currency wars? Will China be dragged into the battlefield? The “prisoner’s dilemma” framework of Game Theory helps us analyse FX policy decisions and sheds some light on China’s strategic position in the currency war. Here is the game: Assume two countries, Europe and Japan, do not communicate with each other on their FX policy moves. Each has the option to either devalue its currency or stay put. If Europe devalues but Japan stays put, Europe gets 1 per cent growth and Japan contracts by 2 per cent, as Europe will be better off by attracting FDI and boosting GDP growth at the expense of Japan. On the contrary, if Europe stays put and Japan devalues, its growth shrinks by 2 per cent while Japan gains 1 per cent. It is clear that no matter what the other decides, each country gets a higher pay-off by devaluing its currency. The reasoning involves a dilemma that neither country knows what the other will do. Strategically, devaluation is the best choice for both Europe and Japan. The latest episode of the currency war has been fought at the expense of the US dollar and the renminbi, whose trade-weighted exchange rates have risen sharply. In China’s case, both its nominal and real effective exchange rates have risen for more than a decade, but the rate of appreciation has sped up since the currency war started in 2010. China’s weak growth and intensifying deflationary pressures are creating concerns among some Chinese officials about the strong renminbi further damaging the local economy. Hence, some market players are predicting that China might join the currency war by devaluing the renminbi to find an escape route. We disagree. The PBoC’s recent move on changing the daily fixing’s calculation is a reform step towards increasing market forces in renminbi trading. Our base case remains that Beijing will continue to resist the devaluation temptation because it: Would not significantly help Chinese exports and economic growth; could lead to destabilising capital outflows due to expectations of further devaluation; could exacerbate the financial burden of those Chinese companies with large and unhedged foreign currency (mainly USD-denominated) debt. Given the prevailing short-term negative sentiment towards the renminbi, the move to reform the daily fixing regime does signal a minor policy shift from the previous “stable renminbi with a strong bias” to now “stable renminbi with a weak bias”, with the bias being determined by market sentiment. A corollary of China joining the currency war is that it could exacerbate the Asian currency battles and send global rates lower. It would also be bearish for commodity currencies, which track Chinese demand. Finally, the resultant market volatility would be bullish for US Treasuries, as capital flows head for a safe haven. This would reinforce the downward pressure on global interest rates. Chi Lo, BNP Paribas Investment Partners