China’s currency has, once again, been weakening against the dollar. It is down by more than 4 percent since October, including a fall of more than one percent just last week. Writing in the New York Times, Landon Thomas, Jr. warned that “China’s decision to push the value of its currency lower has opened a new front of worry for global investors: a potential wave of currency devaluations among the so-called Asian tigers — South Korea, Singapore and Taiwan.” The Times of India echoed this, writing, “China devalued its currency once again on Thursday, prompting fears of a currency war in the Asian region.” In London, The Telegraph joined in with a headline reading, “Currency War Fears Wipe $2.6 Trillion off World Markets.”
Really? Let’s put things in perspective.
Devaluation or depreciation?
First of all, what’s happening to the yuan is a depreciation, not a devaluation. What’s the difference, and why does it matter?
If we assume that every country has either a fully fixed or a fully floating exchange rate, the distinction is simple. A devaluation is a policy-driven decrease in the value of a currency whose exchange rate was previously held fixed. In contrast, a depreciation is a market-driven decrease in the value of a freely floating currency.
Mexico’s devaluation of the peso during the 1994 “Tequila crisis” was an example of the real thing. The Mexican government held its peg until it could hold no more, and then let the peso drop like a stone. On the other hand, the recent decrease in the value of the freely floating Norwegian kroner, which has been caused by lower oil prices, is a depreciation, not a devaluation. The Norwegian authorities didn’t cause it to happen, they just watched.
When there is a decrease in the value of the currency of a country whose exchange rate is neither strictly fixed nor freely floating, we sometimes need to look more closely to know whether we are seeing a devaluation or a depreciation. In such a country, changes in the exchange rate are determined partly by policy and partly by market forces. If the currency is weakening, how do we know whether the central bank is resisting market forces, reinforcing them, or remaining neutral?
Often, the behavior of the country’s foreign exchange reserves gives us the clue we need. Suppose the central bank wants the currency to weaken when market forces say it should not, or to weaken faster than the market alone would cause it to. To achieve its aim, the bank would intervene by buying foreign currency and paying with domestic currency. The increased demand for foreign currency and increased supply of domestic currency would drive the exchange rate down. In the process, foreign exchange reserves would rise.
On the other hand, if the central bank wants to hold the exchange rate steady when market forces are causing it to weaken, or to slow a market-induced downward trend, it needs to mop up excess domestic currency by selling foreign currency from its reserves. In that case, its reserves fall.
From 2010 through 2013, as the yuan gradually rose in value relative to the dollar, the foreign reserves of the People’s Bank of China (PBoC) also rose steadily. (This link takes you to a nice chart provided by Bloomberg.) During that period, there was some truth to the charge that China was manipulating its currency to help its exporters. Even though the yuan was appreciating, the PBoC was was purposely slowing the rate at which it gained value. Chinese foreign currency reserves rose to record levels. However, by the end of 2014, the situation had reversed. The yuan was falling in value relative to the dollar, and reserves were falling, too. Clearly, the PBoC was resisting the depreciation in a way that held the yuan at a value somewhat stronger than its market equilibrium.
In 2015, the situation was clearer still. Over the course of the year, as the yuan moved lower against the dollar, reserves fell by a record $507 billion, capped by a loss of more than $100 billion in December alone. This is no devaluation. It is wrong to write, as Landon Thomas did, of “China’s decision to push the value of its currency lower.” What we are seeing is a market-driven depreciation that the PBoC is working hard to keep from getting out of control.
Let’s turn now to some regional context. We can’t understand what is going on with China’s currency policy by focusing exclusively on the nominal yuan-dollar exchange rate. That is too narrow a lens. We should instead view national economic policies and development trends in the context of real effective exchange rates (REERs).
Real effective exchange rates differ from nominal bilateral rates in two ways. First, they are “real” in the sense that they are adjusted for the effects of differing national rates of inflation. Second, REERs are broadly based weighted averages of a country’s exchange rates relative to those of all its trading partners. (For a more detailed explanation of real and nominal exchange rates, see this slideshow.)
Here is a chart that shows trends in the REERs of the dollar and key Asian economies since 2010:
The first thing we see here is a shared trend toward appreciation for all of these currencies, including the dollar. One of the main reasons for this is that all of these economies are natural resource importers. As world prices for oil and other commodities have fallen, the REERs of all resource importers have tended to appreciate and those of all natural resource exporters have tended to depreciate.
Second, we see that although there is a common trend toward appreciation, the pattern is far from identical. One reason is that the countries in question have different exchange rate regimes—different rules for the conduct of exchange rate policy.
- The US and Korea have freely floating exchange rates. They allow their currencies to move as the winds of supply and demand blow them. That leaves the bilateral exchange rate of the Korean won against the US dollar free to vary in both nominal and real terms.
- Hong Kong’s currency regime is at the opposite end of the flexibility scale. The Hong Kong dollar is pegged to the US dollar in a narrow range centering on 7.8 HKD = 1 USD. It holds that rate steady using a currency board arrangement, one of the strongest forms of a fixed exchange rate. Note, though, that the strict nominal linkage does not mean the REERs of the two currencies move in exact lockstep. The REERs can vary both because of variations in rates of inflation and in the weights that reflect the relative importance of various trading partners.
- Singapore and Taiwan, like China, have intermediate exchange rate regimes under which market forces and central bank intervention jointly determine the exchange rate. Their stabilization policies have limited the variability of their REERs, although both currencies have appreciated moderately since 2010.
Notice that China’s REER has appreciated the most of all the currencies shown. Part of the reason is that the country’s exchange rate regime has changed since 2010. At the height of the global financial crisis, China temporarily pursued a fixed nominal exchange rate vs. the US dollar. After that, beginning in mid-2010 on, China adopted a “crawling peg” arrangement, under which day-to-day variations are limited within a narrow band, but the limits of the band are gradually adjusted up or down in response to market forces. From 2010 to 2013, as discussed above, the PBoC tended to intervene in a way that slowed the rate of appreciation of the yuan. Since 2014, its intervention has mostly aimed to slow the rate of depreciation.
Prospects for a trans-Pacific currency war
Where does this leave the prospect for a trans-Pacific currency war? Will there be a wave of competitive devaluations that will disrupt the global economy and further damage the already-struggling economies of commodity exporters? In particular, how likely is it that the latest depreciation of the yuan will touch off such a conflict?
In my opinion, such a scenario is unlikely.
To begin with, the recent weakening of the yuan would be more likely to touch off a wave of competitive devaluation if it were itself a true devaluation. Instead, as we have explained, we are witnessing a depreciation caused by market forces, with the PBoC actively working against the downward trend. Policymakers in China’s trading partners understand this, even if some in the media do not.
Next, the trade war fears assume that China’s regional rivals are all pursuing policies of active exchange rate management, but that is not the case, nor are all policymakers eager to become more active.
The US dollar is a floating currency, period. The Fed has limited power to control the exchange rate even if it wanted to, which it does not. Korea is in a similar position. It had a bad experience with active exchange rate management in the 1997 Asian currency crisis, and since then, has pursued a hands-off policy. Hong Kong is so strongly committed to its currency board arrangement that it stuck to it even during the 2008 crisis, when many observers thought it would have to devalue.
Taiwan and Singapore do actively intervene in currency markets, but in doing so, they balance a variety of objectives. They watch financial flows, signs of unwanted inflation or deflation, and effects on importers and exporters, as well as the exchange rate policies of trading partners. They would not readily enter into a currency war on behalf of their exporters that would mean sacrificing other objectives.
Finally, although these countries could, in theory, manipulate their nominal exchange rates, nominal devaluation would have limited effect on their REERs. The fact that rivals might match any nominal devaluation is not the only problem. Other things being equal, a nominal devaluation tends to increase a country’s rate of inflation. That in turn causes real appreciation and undermines the hoped-for gain in competitiveness. What is more, devaluations by commodity importers would not remove the changes in global terms of trade, which were the cause of real effective appreciation in the first place.
The bottom line
This post has given several reasons why rational policymakers in Asia-Pacific region would hesitate to initiate or join a series of competitive devaluations. Of course, we can’t be sure that political authorities will always act in their countries’ rational self-interest. Still, don’t bet on a pan-Asian currency war any time soon. There are other risks to the global economy that loom larger.