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Economy

The real reasons why China devalued

The most shocking thing about the world's reaction to China's decision to devalue the yuan was that anyone should have been surprised. For those who have watched China's deteriorating economic growth since late 2014 and the ineffectiveness of monetary easing by the People's Bank of China, the country's central bank, currency devaluation appeared to be not only logical, but also inevitable.

    Since recording its last double-digit rate of 10.4% in 2010, China's economic growth has slowed by 3 percentage points over four years to 7.4% in 2014. In response, Chinese policymakers injected massive amounts of credit into the economy. Although estimates vary, total credit growth from 2011 to 2014 probably equaled 100% of Chinese gross domestic product, raising the debt-to-GDP ratio to around 280% at the end of 2014, according to McKinsey, the business consultancy.

    Undeterred by the prospect of creating a financial crisis, the Chinese government continued to double down on monetary easing. Since last November, the PBOC has cut interest rates four times by a total of 115 basis points and lowered the reserve ratio (the amount of cash banks are required to hold) three times by 150 basis points.

    This injection of new credit did not do much to revive China's investment growth, but it did help inflate a gigantic stock market bubble that temporarily created a mirage of prosperity.

    Unfortunately, the bubble started to collapse in mid-June, forcing Beijing to launch an aggressive and hugely expensive rescue operation to prevent share prices crashing. Meanwhile, the economy deteriorated further. In July, Chinese exports fell 8.3% while its purchasing managers index reading was 47.8%, the lowest in two years.

Lessons

If we have learned anything about how Beijing deals with difficult economic challenges since the 2008 global financial crisis, it is about its leaders' attitude of "whatever it takes" and "shoot first (ask questions later)." The decisive factor in any decision has always been maintaining economic growth.

    To be fair to President Xi Jinping and Premier Li Keqiang, they inherited an economic mess in late 2012. A decade of prosperity fueled by explosive export growth, following China's entry into the World Trade Organization and a resulting real estate and infrastructure investment boom, dampened appetite for reform and created an economy saddled with debt, a property bubble and immense manufacturing overcapacity.

    After becoming head of the Communist Party in 2012, Xi knew that the party's long-term survival and his own political fortune would rest on reviving growth through structural reforms. Exactly a year after his appointment, Xi launched an ambitious long-term blueprint for economic reforms.

Falling short

Unfortunately, only modest reforms, mainly in the financial sector, have been implemented in the last two years. Besides being unfairly blamed for fueling the stock market bubble, the liberalization of interest rates and capital controls had no discernible positive impact on growth. Meanwhile, measures more urgently needed, but also more painful, such as financial deleveraging, closing "zombie" firms, and downsizing state-owned enterprises, were delayed or resisted.

    As long as Xi enjoyed an extended political honeymoon as a result of his crackdown on official corruption, he did not have to worry too much about poor economic performance. But things have changed in recent months.

    After tightening up and jailing many corrupt senior officials, known as "tigers," Xi apparently is running out of easy targets. Like a military conflict, an anti-corruption campaign requires constant escalation to demonstrate the dominance of the victor.

    Xi has become a victim of his own early success. Now he finds himself in a dilemma: to maintain credibility and political dominance, he needs to go after even bigger tigers. Given the rot at the top of China's Communist Party, there are plenty of super tigers left to catch. But the political costs will be very high as Xi increasingly risks an open split with the most powerful factions in the party.

    At the same time, the law of diminishing returns has set in. Ordinary people who have been cheering the fall of tigers and junior official "flies" are now gaining less satisfaction from the spectacles of formerly high-flying officials confessing their sins in court. It is nice to have a less corrupt government, but it would be even nicer to have a cleaner government that can also deliver economic prosperity.

   With less than two and half years left in his first term, time is running out for Xi to demonstrate his capability as a strong leader who can both clean house and revive China's sagging economic fortunes. If he fails to deliver real economic improvement in the next two years, Xi will have considerably less political capital in the fall of 2017, when the party convenes its 19th congress to decide whether to make him a lame duck by anointing his successor.

Pivotal event

The pivotal event, in retrospect, that influenced China's decision to devalue was the rise and fall of the country's stock market bubble. The bubble initially boosted confidence and, had it lasted, might have lifted short-term growth. But its untimely collapse forced Beijing to resort to desperate measures.

   In the immediate aftermath of the bursting of the bubble, the Chinese government pumped more than one trillion yuan into the stock market to support overvalued equity prices, unnecessarily fearing that further market declines would trigger a runaway financial crisis that would further depress growth.

   As Beijing had relied principally on the PBOC's liquidity support to prop up the market bubble, it then curbed the central bank's future capacity to stimulate the economy. After all, you can only print so much money without causing high inflation and other serious macroeconomic problems.

   That left Chinese policymakers with only one quick solution to reinvigorate growth, which was devaluation. Of course, Beijing has skillfully packaged this move as part of reforms to make the yuan more flexible. In a technical sense, this is true.

   But when you examine the domestic political context of the decision to devalue the currency, it can be seen as a desperate -- and a likely unsuccessful -- act to export China's economic woes to a global economy that mirrors the country's own structural economic maladies: anemic demand, mountainous debts, and excess capacity.

   Those familiar with Beijing's "whatever it takes" and "shoot first" modus operandi cannot help but feel that they are watching the same horror movie all over again.

Minxin Pei is a professor of government at Claremont McKenna College and a non-resident senior fellow of the German Marshall Fund of the United States. 

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