How To Create A Chinese Economic Crisis In 3 Easy Steps

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by: David Beckworth

First, peg the Chinese yuan to another currency that has been rapidly appreciating over the past year...

...this will choke the tradeable sector...

... and really put a damper on nominal spending growth.

Second, respond to the above economic weakening by easing domestic monetary conditions. Over the past year, the People's Bank of China has done so with five cuts to its prime lending rate and several large reductions in the required reserve ratio for banks.

Third, allow nervous investors to pull their capital out of China. Investors have come to expect a large yuan devaluation given the above developments. For the easing of domestic monetary conditions has put downward pressure on the yuan while the dollar peg has pushed it up inordinately high, creating an imbalance. The only way China can maintain this imbalance is to defend its dollar peg by burning through its foreign exchange reserves...

... a response that becomes more expensive the tighter Fed policy becomes...

... but there is a limit to burning through these assets since China still needs some foreign reserves buffer. Ambrose-Evans Pritchard reports some observers are already wondering if China is getting close to its buffer limit. If so, China will be forced to devalue. This is what investors are now expecting and therefore are eager to get out. This puts further pressure on China's stock of foreign reserves.

Note that devaluing the yuan will be costly too. Many Chinese firms, previously expecting the dollar peg to hold, have taken out lots of dollar denominated debt. So either China burns through its reserves or it increases the private sector's real debt burdens. There are no easy choices here.

China, in short, has backed itself into a corner because it has attempted to do all three goals of the impossible trinity...

... something the emerging market crisis of 1997-1998 taught us does not end well. But China is trying anyways and the recent stock market roller coaster ride is just one of many adverse outcomes likely to come out of these efforts. Fortunately, most emerging countries are not making this mistake as noted by Greg Ip. That is good news. The bad news is that it will not be easy for China to undo the three steps it has taken towards doing the impossible trinity.

P.S. For a broader perspective that makes the same point, see this post by Lars Christensen.