China must devalue the renminbi or lose its hard-won reputation for economic management

Three independent announcements have shaken the world’s capital markets of late: first, the Bank of Japan’s surprise announcement of negative interest rates; second, the US Federal Reserve’s clear signal that it plans to tighten monetary policy this year; and, third, China’s announcement of a record low GDP growth rate.

The obvious consequence is that China must devalue the renminbi immediately. Failure to do so will not only hurt Beijing’s hard-won reputation for economic management (especially with the public) but will simply delay the inevitable final reckoning and exacerbate current problems.

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The Fed has been signalling since 2013 that it would be tightening monetary policy and finally raised interest rates last December. Markets have been anticipating the rise for over 18 months and capital has flowed from all over the world to the US, resulting in the dollar getting stronger versus every other currency.

At the same time, the European Central Bank and the Bank of Japan have been engaged in a race to the bottom: both have been increasing money supply and lowering interest rates in an unprecedented manner, culminating in the recent move to negative rates. This has, of course, exacerbated the flow of capital into the US and the dollar’s strengthening.

The combination of these two forces has left China facing a dilemma ... or, rather, a trilemma.

In a famous paper for which he won the Nobel Prize, Robert Mundell showed that a country can have only two of the following: Free capital flows; fixed exchange rates; and independent monetary policy.

In other words, if a country has no capital controls and a fixed exchange rate, then it loses its monetary policy. Indeed, not only does it lose the ability to set interest rates, its interest rate is automatically set by the country to which its exchange rate is fixed.