China's recent devaluation of the yuan has thrown the market on its heels, but it really should come as no surprise. More importantly, it may signal the re-emergence of liberalism as the dominant ideology in China.
The devaluation of a broad range of currencies against the dollar does not reflect the weakness of the US's trading partners individually. Rather, it reflects the strength of the US economy. It is not the yuan, Euro or yen depreciating, but rather the dollar strengthening.
How do we know this? On the graph below, we can see an index of US exchange rates compared to other key currencies--the Euro, yuan, yen, and won--as well as a broad trade-weighted US dollar index. In every case bar China, the currencies of US trading partners began to depreciate in September 2014, falling essentially to April of this year before stabilizing and then resuming a fall in the last six weeks or so. It is highly improbable that all of the US's trading partners should simultaneously weaken and only the US remain untouched. The far more likely interpretation is that the US experienced some country-specific event which led to the strengthening of the dollar versus virtually the entire gamut of other currencies.
How could that be? What else was happening in late summer 2014 when the devaluations began?
Quite a lot, it would seem. US oil production growth was soaring, and by September 2014, was nearly 1 mbpd higher than it had been the previous winter. Indeed, by year end, the US oil supply would be a whopping 1.4 mbpd higher than it had been a year earlier. So rapid was US oil production growth that it would ultimately undermine global oil prices. This was confirmed when the Saudis announced last November that they would not cut production, precipitating a historic collapse in oil prices. By the time the dust had settled this past January, oil prices were only half of their level of six months earlier. They remain there today.
The US is a major oil importer; indeed until recently the leading oil importer in the world. Oil imports have been a major driver of the US trade deficit since the early 1980s. But now, with surging shale production, US oil imports have plummeted, from 12 mbpd in 2005, to only 4.5 mbpd (net of product exports) today. Imports fell by 1 mbpd (20%) in 2014 alone.
As a result, the US trade deficit in oil has shrunk dramatically, from $30 bn per month from the dawn of the shale revolution in early 2012, to a mere $6 bn recently. On an annual basis, the trade deficit reduction is more than $300 bn, almost 2% of GDP.
What would Americans do with the savings? If they are paying less for oil, are they buying something else? Americans could have simply saved the money and seen the trade deficit decline pro rata with oil imports. Or they could choose to re-direct the savings from oil imports to importing goods and services of other kinds. Last December, I wrote that I believed that the US trade deficit had settled into a kind of comfort zone, and as a result, Americans were likely to spend their oil savings on importing other things, like cars from Germany and Japan. And so it has proved.
Why has the US settled into this 'comfort zone'? What has induced Americans to buy more non-oil imports? One is left with the impression that the capital account is implicated. The world appears to need the US to issue debt--about $40 bn per month. To achieve that goal, non-oil exporters have had to depreciate their currencies. It is this depreciation which has induced Americans to buy more non-oil imports.
Thus, I would argue that the evidence suggests that surging US shale production, coupled with a collapse of oil prices, led to the appreciation of the US dollar--particularly after the country had reached its comfort zone in terms of the overall trade deficit. Put another way, US shale producers can take full credit for the appreciation of the US dollar, not to mention shrinking the trade deficit by an astounding 2% of GDP.
And that brings us back to China. For the benefit of the reader, I reprise the exchange rate graph from above. As the graph shows, virtually every major trading partner of the US devalued its currency, with one exception: China. Indeed, through November of last year, the yuan was undergoing a creeping revaluation, to be replaced this past spring with a de facto dollar peg.
Now why would China do that? One might argue that it was a mistake of the PBOC, China's central bank. But that is highly unlikely. China's technocrats are excellent, and one has to imagine they review their exchange rates every day. The graph above suggests that they appreciated they had an incipient exchange rate problem no later than December of last year, when the creeping appreciation policy ended. Indeed, were one to speculate, PBOC analysts probably warned the government six months ago that, unless China could reduce its unit costs ten percentage points faster than the Koreans, China would experience deteriorating competitiveness and problems with exports within a few months. And so it proved. China's export performance has been terrible recently, and in fact the impetus for the recent devaluation. This devaluation has been taken by the western media as reflecting weakness in the Chinese economy. The better interpretation is that the devaluation represents the correction of an earlier policy mistake--the failure to devalue in line with other economies in the region. The situation in China is not getting worse; the overdue devaluation suggests it just got better.
But still, why then did China hang on to a de facto peg for so long? To answer that question, we might ask who has the power to override the PBOC's technocrats. And that's simple: political leadership.
Socially conservative governments the world over believe in national strength. And that includes a strong currency. Not uncommonly, a devaluation is taken as a sign of national weakness, failed policy, or political vulnerability. Politicians--particularly conservative politicians--don't like it. Therefore, it seems plausible that China alone hung onto a dollar peg because political leadership ordered them to do so, most likely against the advice of the PBOC's staff. On the other hand, the devaluation suggests that the PBOC view has been vindicated. If this interpretation is correct, the PBOC technocrats will not be challenged again during the Xi government.
Were this the only news story out of China, the narrative might end here. But it's not. China also recently announced that it is ending construction--or at least, land reclamation--in the South China Sea. If true, this is an important development, as it also signals a turn towards more liberal foreign policy. China will both have need of, and a right to, the 'string of pearls' bases necessary to protect its growing Middle East oil imports. This is no different than the bases the US uses around the world. However, the means by which China has pursued this policy has raised the hackles of virtually every other country bordering the South China Sea, as well as drawing the US into the conflict.
It is hard to trade with people you are threatening militarily. China's talent pool is not limited to the PBOC; it's diplomatic corps is also excellent. And the country's diplomats have no doubt warned the Xi government that island building policy will lead to the political isolation of China and increased dependence on such low-brow friends as the Russians (who have managed to draw sanctions upon themselves and plunge the country into recession). A confrontational policy makes China look second-rate and frankly, un-cool. The voices promoting a more nuanced approach are perhaps finally being heard.
Incoming politicians often have strong views of the world which require modification over time. Hardline strategies sometimes evolve into greater accommodation. If this week's news holds up--the devaluation is successfully implemented and China re-thinks its maritime strategy--then we may be seeing a broader shift in ideology and policy. China may simply have progressed too far to become a top-down, power-based country. The technocrats and the businessmen may once again set the tone and put China back on the track which has brought it success since the days of Deng Xiaoping.
If so, China could come back strong. Very strong. Twelve months from now, it could be the hot ticket once again.