The $3 Trillion Question

Buffeted by a slowing economy, a falling stock market, and a rising tide of money leaving the country, China is flirting with weakening its currency, the renminbi (RMB). Despite repeated — and very high-level — pledges to maintain its value, Beijing quietly let the RMB slip 5 percent against the U.S. dollar in 2015. Many see its decision in December to switch the RMB’s peg from the dollar to a basket of currencies as a back-door way to piggyback on the weakening of other currencies against the dollar. Meanwhile, a growing chorus of economists, hedge funds, and policymakers are saying that China must “go with the market” and let its currency fall to save its stumbling economy. “China should stop resisting Renminbi depreciation. The currency is overvalued,” tweeted economist Jeffrey Sachs. In mid-January, at the World Economic Forum in Davos, Switzerland, Goldman Sachs President Gary Cohn agreed China has little choice: “They may have to do something in the next six months.… Do I believe they will end up devaluing the currency? I do.”

The problem is, the chorus is wrong. A weaker RMB won’t fix the problems with China’s economy that are causing capital to flee; it will only make them a lot worse. Only reform and rebalancing — moving away from a reliance on exports and investment to drive growth and toward a more balanced, consumption-based economy — can put China’s economy back on track. Beijing drawing down on its bloated foreign currency reserves to defend the RMB — instead of letting it slide — is integral to making that rebalancing happen.

Economists are prescribing the wrong solution for China because they are used to dealing with an entirely different set of problems. Countries that suffer a “currency crisis” — unrelenting pressure for their currency to fall in value — are usually debtors that run a trade deficit. If their exports falter, or import prices spike, or foreign financing to cover their trade gap dries up, they will run short of the foreign currency they need to pay their bills. The amount of local currency it costs to acquire (the now scarce) foreign currency will rise, making imports more expensive and locally made goods more competitive, at home and abroad. The shift in the exchange rate sends a corrective signal throughout the economy — consume less, save and produce more — that pushes payments back into balance. India’s currency crisis in 1991, financier George Soros’s raid on the British pound in 1992, Mexico’s “tequila crisis” in 1994, Asia’s financial crisis in 1997, and Argentina’s debt default in 2001 all fit this familiar pattern.

The country’s central bank can stave off this often painful adjustment, for a time at least, by selling off its own foreign currency reserves or by raising interest rates to try and attract more capital. But if citizens think policymakers lack either the means or the resolve to hold the line, they will rush to change out of their home currency before it depreciates — intensifying the downward pressure on that currency. That’s why most economists advise letting the currency fall — or even getting out ahead of the situation by devaluing it so much lower that people will expect it to then rise — to avoid making the adjustment harder than it needs to be.

China is different. Like Japan in the 1980s, China has piled up a precariously high level of internal debt, but in relation to the rest of the world, it is a creditor nation with a trade surplus. Its problem is not a reliance on external financing to support consumption, but an excessive reliance on external demand to support domestic output and return on investment. The corrective is a stronger, not a weaker, currency that enhances the purchasing power of domestic consumers while discouraging the build-out of even more overcapacity.

The question is not whether China is facing an economic crisis, but what kind of crisis. Crises faced by creditor nations have different origins, impose different constraints, and have fundamentally different solutions than those of debtor countries. When Japan suffered a sharp slowdown in growth starting in 1990, accompanied by a property and stock market collapse, it did not face a currency crisis; in fact, the yen actually rose in value.

Yet the RMB has come under strong downward pressure in recent months. The current pressure isn’t a signal to rebalance — that came in the form of a 36 percent rise in the RMB with relation to the dollar since 2005 — but the result of Beijing’s consistent failure to heed that signal, by flooding the Chinese economy with cheap credit, erecting subtle trade barriers, and propping up money-losing industries. Now, falling asset prices and investment returns, along with doubts about the coherence of Beijing’s policy response, are causing capital to leave the country. Despite a record trade surplus, China is hemorrhaging cash — with an estimated $1 trillion in capital outflows in 2015.

Responding by letting the RMB weaken further would be counterproductive on multiple levels. Far from reducing capital outflows, expectations of a falling RMB would only intensify them, pushing the currency down even farther. If expectations were the main problem, then a sudden, large devaluation might preempt and defuse them. But neither gradual depreciation nor a sudden devaluation would solve the major reason money is leaving China: Beijing’s failure to rebalance its economy. In fact, a weaker currency, by subverting the purchasing power of China’s consumers and fostering unsustainable forms of growth — in other words, favoring savers and production at the expense of consumer purchasing power — would only worsen the problem.

Even the benefits of a weaker RMB would likely prove illusory. Other countries would quickly come under pressure to devalue their own currencies, erasing whatever advantage Beijing sought to gain. In 2015, a stronger U.S. dollar — against the euro, yen, and a host of emerging-market currencies — cut noticeably into U.S. growth and corporate earnings. Another round of competitive devaluation, triggered by China, could tip the United States into recession. Weakening the RMB would do little to boost China’s exports, if it sinks one of China’s top markets.

The alternative — which China has been doing, at least for the most part — is to support the RMB by drawing on the country’s huge stockpile of foreign currency reserves. Over the past two decades, China’s central bank accumulated nearly $4 trillion by intervening to keep the RMB from rising. Since June 2014, it has sold $663 billion of that defending the exchange rate.

Critics raise three main objections to supporting the RMB; all of them miss the mark.

First, they argue that drawing down on reserves tightens China’s monetary policy, just when it should be easing. When the central bank sells foreign currency to meet the demand for payments, it buys RMB in exchange, shrinking the domestic money supply. While it can “sterilize” this effect by injecting more RMB, critics contend that a China suffering from producer price deflation for the past three years should be pumping money into its economy, not letting it drain out.

They’ve got it wrong. Falling prices for factory goods in China are the result of massive overcapacity, fueled by years of too much credit. Pour in even more credit — without first instituting serious reforms — and the money will either flow into speculation, more overcapacity, and more deflation, or it will result in more capital leaving the country. The only way for China to cure deflation is to rebalance its economy, by supporting consumer purchasing power and reining in over-investment. Using the reserves to support the RMB aids that process.

Second, critics charge that by defending the RMB, China is “wasting” precious resources, when it should be letting market forces decide the exchange rate. They suggest a parallel with China’s ham-fisted and short-sighted efforts to prop up its stock market.

The notion that letting the market work means letting the RMB float has a strong superficial appeal. But unlike the market for stocks, steel, or shoelaces, central banks make the market in their own currency. Demand for a given currency depends on the market, but the central bank decides how much to supply. Assuming free flows in trade and investment, the central bank can set the interest rate and let the market determine the exchange rate, or it can set the exchange rate and let the market determine the interest rate. Neither approach is intrinsically more market-oriented than the other.

Beijing’s nearly $4 trillion in foreign currency reserves kept the RMB cheap and gave rise to huge global imbalances. For Beijing to sit on those foreign exchange holdings and let the RMB fall in order to preserve those imbalances would be a verdict handed down by misguided policymakers, not the market.

Many economists agree that the RMB is now overvalued. What critics who seize on this point fail to recognize is that defending an overvalued currency by drawing down on its reserves is the mechanism by which excessive savings are transformed into greater consumer purchasing power. These reserves aren’t “wasted”; they are reintroduced into China’s economy, where they prop up living standards in the face of an otherwise wrenching economic adjustment or are redirected toward better investments abroad. A huge pile of foreign currency reserves is useless for any other purpose than nudging China’s economy in a more sustainable direction, and right now, China needs to use them to this end.

The third objection is that defending the RMB is unsustainable because at some point China will run out of foreign exchange reserves. The pace at which China has been drawing down reserves — an average of $37 billion per month over the past year-and-a-half — has some people alarmed. But with roughly $3.3 trillion left, Beijing could keep selling its reserves at twice that rate for almost four years without running out. The International Monetary Fund suggests that China “should” hold $2 trillion or so for prudential purposes, but that’s so Beijing will have enough to draw on when needed — like now. Critics will point out that not all of China’s reserves are fully liquid and that if everyone in China exchanged their RMB for dollars, the equivalence of trillions of dollars in foreign currency reserves could be gone in a flash. All very true, but as with any bank run, what matters isn’t the ability to pay out all claims, but the ability to pay enough to restore confidence.

That word, “confidence,” cuts to the heart of the matter. What China is facing with these capital outflows isn’t a payments crisis but a crisis of confidence, one that can only be solved by rebalancing its economy. Supporting the RMB sends the right price signals to facilitate that move while buying time for more substantive reforms to unlock a less lopsided path to growth.

Of course, it is possible that Beijing will squander this opportunity. Or that it is already too late, that nothing at this point will restore confidence, and all the money will simply flee. But while China may risk failure defending the RMB, not doing so virtually guarantees failure. If Beijing lacked the resources to hold the line, the IMF and other central banks possibly could augment its firepower — and ward off speculative pressure — by lending China hard currency or swapping it for RMB. Buying time for China to rebalance might well be to their advantage, compared to the potentially disastrous global consequences of competitive devaluation.

The experts calling for a weaker RMB are like doctors used to seeing patients suffering from blood clots and successfully curing them by prescribing blood thinners. Then in walks a hemophiliac — and they still prescribe blood thinners. Different disease, wrong medicine. The economists treating an ailing China like yet another emerging-market debt crisis need to re-examine the patient and rethink their exchange rate prescription, before they end up doing more harm than good.

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