An awful lot of guff gets talked about China's exchange rate policy, much of it by people who really ought to know better. Just a few months ago the big concern among analysts was that huge inflows of short-term capital from corporations and investors anticipating yuan appreciation would flood the financial system with liquidity and fuel runaway inflation. This week, after President Hu Jintao complained about China's declining competitiveness and the central bank nudged the yuan a smidgen lower against the US dollar, analysts are fretting about the exact opposite. Now they are worried that Beijing will devalue the yuan. That, they fear, will ignite a round of beggar-thy-neighbour copy-cat devaluations around Asia, trigger uncontrollable capital outflows from the mainland, damage consumer demand within China and exacerbate global financial imbalances, worsening the current economic downturn. Let's deal with these fears one by one. First, it is absurd to argue that the fall in the yuan this week will set off a wave of competitive devaluations around Asia. As the first of the two charts below shows, over the 12 months to the end of last week, the yuan had appreciated 8.3 per cent against the dollar. On Monday it dropped by 0.8 per cent, before strengthening a touch to end yesterday's trading 0.3 per cent below last Friday's close. That's the small downward blip you can see at the far right of the first chart; a fall against the US dollar for sure, but hardly a massive devaluation. A drop of such small magnitude, even if it is repeated over many weeks to come, will not beggar any of China's Asian neighbours. That is because the rest of East Asia's currencies (with the exception of the Japanese yen, which marches to a different drummer) have already fallen heavily against the US dollar over recent months. That means the yuan has appreciated dramatically against other regional currencies. As the second chart below shows, between mid-July and late November, the yuan rose by a massive 48 per cent against the Korean won. Its subsequent 2 per cent fall is not going to turn any Koreans into beggars by undermining their international competitiveness. Talk of yuan depreciation triggering uncontrollable capital outflows from China is also nonsense. Certainly this week there has been a rush for US dollar funding by Chinese companies who until now have preferred to hold yuan. But with US$2 trillion in foreign reserves, Beijing has more than enough foreign currency to meet any demand, and to halt the yuan's depreciation and reverse the outflows whenever it wants. The charge that yuan depreciation risks depressing Chinese consumers' real incomes, weakening domestic demand and exacerbating the global slump is more serious. Many economists argue that China should be doing the exact opposite: appreciating the currency to boost real incomes and hence consumer demand. But seen from Beijing it doesn't look that way. The mainland authorities are already trying hard to boost the domestic economy with stimulus measures, but they can't conjure up consumer demand overnight. In the meantime, with exports flat or even falling in inflation-adjusted yuan terms, Beijing is getting increasingly nervous about mounting job losses in the export sector. Given the paucity of external demand, a little yuan depreciation won't reverse the process, but it may just help preserve some jobs, which to Beijing is no bad thing. There is also another reason why the authorities might favour a weaker currency. As demand, especially in the property sector, has weakened and commodity prices have tumbled, the balance of risk in the Chinese economy has swung away from inflation towards a danger of deflation. Falling prices are something Beijing badly wants to avoid. They kill demand and make debts harder to service, which would weaken an already shaky financial system. If a softer yuan bumps up import prices and introduces a little inflation back into the system, it may be no bad thing.
