China's Currency Responding More Closely to Market Forces

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China's surprise devaluation of its currency this week will likely boost the country's exports and generate more jobs at home, Stanford scholars say.

Since Tuesday, China's currency has fallen 4.4 percent, sparking concern among the numerous countries intertwined with the world's second largest economy. There is more to the story, according to China experts at Stanford.

A. Michael Spence, a Stanford economist who has studied China, said that China's currency devaluation indicates it is struggling to meet its 7 percent economic growth target for this year and that domestic growth engines are not working fast enough. 

"In addition, the devaluation relative to the U.S. dollar probably reflects the strength of the dollar. The picture would look different relative to the euro and yen. The (Chinese) stock market volatility did not help this year," said Spence, professor and dean emeritus of the Graduate School of Business at Stanford. In 2001, he was awarded the Nobel Memorial Prize in Economic Sciences for his contributions to the analysis of markets with asymmetric information.

As for why China is devaluing its currency, Spence said that Chinese officials are trying to increase exports by making Chinese goods cheaper. Chinese exports fell 8 percent last month compared with a year ago.

Spence advises that China should use its considerable assets to accelerate reforms and long-term growth-oriented investments as it grapples with a slowing economy.

It is a delicate economic time for China, as Spence and other experts say the country could be caught in a "middle-income trap" – a common danger for developing economies when they begin to lose their competitive edge in exporting manufactured goods because their wages are on a rising trend.

"To simplify, the middle income transition requires a major shift in the growth dynamics and supportive policies. Many countries do not make this shift. It can be thought of as sticking with a successful formula beyond its useful life," said Spence, also a senior fellow at Stanford's Hoover Institution.

Critics have said China manipulates its currency to gain a trade advantage. Some U.S. policymakers have long argued that the renminbi is undervalued and that this has influenced many American companies to move production to China.

Stanford economist Nicholas Hope said the devaluation – though it received widespread news coverage – is such a small one that its impact is more symbolic than substantive.

"The chief effect of the Chinese move is to serve notice that China really is managing its exchange rate on a basket of currencies rather than a loose dollar peg," said Hope, director of the China Program for the Stanford Center for International Development, which is part of the Stanford Institute for Economic Policy Research.

Hope said several factors could have contributed to the sudden adjustment of the fixing point of China's currency to the U.S. dollar.

"First, for some months the rate has languished at the weak end of the range around the old 6.1162 fixing (of the currency), and the adjustment recognizes what the market has been telling the Chinese authorities," he noted.

Second, after a lengthy period of stability at around 6.21 renminbi yuan to the dollar, China might be reminding market participants (along with the International Monetary Fund) that the Chinese currency floats, even if it is not freely flexible, according to Hope.

Third, after announcing a decline in international reserves for a third consecutive month, China might be discouraging speculative capital outflow by a small pre-emptive weakening of the currency, he said.

"Finally, given that export performance has disappointed, and even though the current account remains in surplus, the move is in the direction of maintaining China's international competitiveness," Hope said.

Hope suggested that China would be better off if it accelerated structural reforms that contribute to greater efficiency of investment and higher productivity. "Appropriate policies to boost domestic demand could help as well," he added.

Overall, he believes the impact of the devaluation will be minimal.

"To the extent that others are affected, those countries that compete with China for sales to the European Union and the U.S. markets are likely to experience the biggest impact," Hope said.