Have China's financial chickens come home to roost?

Last Thursday, the Dow Jones industrial average fell 2% in response to bad economic news from China.  Before trading was suspended, the Shanghai stock market index fell by 7%, in response to news of slowing growth.  According to reports filtering out of China, the real growth rate is significantly less than the stated growth rate of about 7%.

Experts have cited a variety of reasons for China's slowing growth, but China's long history of currency manipulation has usually not been among them.  China's national currency, the renminbi, is not traded on the open market like the dollar; instead, the Chinese government sets a fixed exchange rate.  Historically, they set the exchange rate well below the market value as a way to boost exports, angering U.S. lawmakers.

Ceteris paribus, a lowered exchange rate makes one's goods cheaper, boosting both exports and economic growth, and historically, this has been China's reasoning in holding down the value of their currency.  However, currency devaluation has a number of side effects that may be finally catching up with China.

Demand-Side Inflation

Devaluing one's currency makes imported goods more expensive, reducing the buying power of domestic consumers.  Further, by eliminating foreign competition and increasing exports, it will increase the price domestic consumers pay for locally produced goods.  Given this, it is unclear to what degree exports have simply replaced domestic sales instead of increasing overall production.

Supply-Side Inflation

Devaluing one's currency makes importing raw materials and machinery more expensive.  In technical terms, it shifts the supply curve right.  In laymen’s terms, increased production costs are passed on to the consumer.  For a massive importer of natural resources like China, currency devaluation is likely to be a bad trade-off.

Asset Devaluation

If the value of my house falls from one million dollars to half a million dollars, I am half a million dollars poorer.  When China devalues its currency, it makes the holders of Chinese currency poorer.  It defies common sense to believe that one becomes richer by making oneself poorer.

The most obvious effect of asset devaluation is capital flight.  Chinese and foreign investors have been pulling their money out of China, probably because they fear that the government will devalue the renminbi in order to boost exports.

Economists have cited weak domestic demand, inflation, and capital flight as key reasons for China's economic slowdown, but they have missed the most obvious factor underlying these problems.  Devaluing one's currency reduces the purchasing power of domestic consumers, drives up costs, and leads to capital flight.

Some will argue that China's currency is no longer undervalued and that the Chinese economy actually grew faster when their currency was more clearly undervalued.  However, that argument ignores some basic facts.  China's economy grew fastest when wages were low and their comparative advantage in low-wage industries was greatest.  As wages have risen, China lost its comparative advantage, and now manufacturing is moving to other low-wage countries.  China's economy grew in spite of its currency manipulation, not because of it.