The Chinese Puzzle

Before we discuss what China’s slipping currency means to investors, let’s take a moment to enjoy what’s been happening to our chief economic rival. It’s called schadenfreude, or pleasure derived by someone from another’s misfortune.

For years China has manipulated its currency so Chinese exports are cheap vis-à-vis the U.S. dollar. Also, its stock market has been buoyed not only by its strong economic growth, but by lack of transparency, shadowy government intervention and manipulation. And now its market is down about 25% from its peak in April as the country is apparently having a tough time moving to a more consumer-based economy.

Probably in part due to the declining stock market, the People’s Bank of China (PBOC) on Tuesday first allowed its currency, the yuan, to drop 2% relative to the dollar, and as of yesterday it was down 4%. A cheaper currency means Chinese exports will be cheaper, and so boost its exports and the stock market.

The Chinese government also tried to stop the stock market slide by lending billions to big Chinese brokerage firms so they can buy more stocks, and increasing government spending and stopping trading in many stocks.

China believed it could reap the benefits of capitalism while controlling it through central planning, which now looks about as effective as putting a saddle on a cyclone. The late Charles LaLoggia, a brilliant financial newsletter writer and columnist I worked with in the 1980s, used to preach about all the trouble Japan was heading for with the manipulations it was doing to its own economy. Japan was defying the laws of economics, and its levitation act would eventually end in a crash. Which, of course, it did.

As I’ve been watching the China miracle grow to mythic proportions I’ve often thought about my friend Charlie’s Japan call.

Of course China isn’t Japan, and while we’re in for a bumpy ride as China takes its medicine, the prospects of a China Syndrome meltdown seem remote.

As my colleague Ben Shepherd wrote in Pacific Digest (the ezine of our Pacific Wealth publication) yesterday, letting the yuan float down not only will boost exports, it will help China get its currency added to the Special Drawing Rights (SDR) basket of currencies maintained by the International Monetary Fund. “That would essentially elevate the yuan to a global reserve currency, a status coveted by the PBOC.”

And while China’s missteps in moving to a more consumer-based economy are worked out (good luck in getting the wisely thrifty and risk-adverse Chinese people to spend and invest more), it’s GDP growth may dip—gasp—below 7%. We would kill for half of that.

And speaking of the U.S., we still have the world’s biggest economy, and while it’s not growing robustly, it is growing, which will mitigate China’s slowdown.

China’s purchasing of commodities was already slowing, but the new wrinkle with a cheaper yuan is purchases of imported consumer and other manufactured goods will drop as they become more expensive to the Chinese. This caused some market panic this week, as the Dow dropped more than 200 points Tuesday and started Wednesday with a more than 200 point decline, before finishing break-even.

Yesterday the Dow edged up a bit, showing that cooler heads had prevailed, and the markets were taking the PBOC at its word that the yuan’s slide had stopped.

Many in the international banking community, such as the International Monetary Fund, actually praised China for letting market forces have more of an influence on its currency. But with his typical understatement, GOP presidential candidate Donald Trump said China is “making it absolutely impossible for the United States to compete.”

This is not to minimize the problems China is suffering. If it continues to devalue its currency, it could spark a currency war in which countries lower the value of their currencies in a vicious cycle so their goods are not priced out of international markets. And if China is hiding deeper economic ills, and its growth grinds to a halt or it goes into recession that will be a major blow to the world’s economies.

China is the biggest trading nation, and given the debt load so many of the world’s economies carry right now, we need China growing to help us all grow so we can keep paying our debts.

But for now we can afford to enjoy that a little smug has been wiped off China’s economic face.