Michael Pettis is a finance professor at Peking University and a senior associate at the Carnegie China Center.As China’s economy continues to slow and the renminbi weaken in the face of Covid lockdowns, the Ukrainian war, US monetary tightening and financial outflows, there has been a rising chorus of voices calling for Beijing to devalue the renminbi. A cheaper currency, the argument goes, would benefit Chinese manufacturers by allowing them to boost exports, which should in turn boost economic growth. Lo and behold, the renminbi has weakened significantly lately. But this view is based on a misunderstanding of how currency depreciation works. While a weaker currency would indeed increase China’s external competitiveness, it would also worsen domestic imbalances within the Chinese economy, and therefore reduce overall growth.This is probably why after two years of trying to moderate its rapid rise, the PBoC has responded to recent currency weakness by implementing measures to support the renminbi. On Monday, for example, it lowered the foreign exchange deposit reserve requirement for banks.The reason many analysts have misunderstood how currency depreciation works in China is because they assume that a change in the value of a currency affects the economy mainly by changing the international prices of imports and exports. But in fact currency movements work more generally by changing the distribution of income within the economy.A depreciation of the currency has an effect similar to a tax on consumption combined with a subsidy to manufacturers. By increasing costs to consumers and reducing costs for producers, It effectively transfers income from households to businesses.All income is either saved or consumed, but while businesses save all their income, households consume most of their income. For that reason a transfer of income from households to businesses automatically lowers domestic consumption and boosts the national savings rate.It also automatically improves the balance of trade. Raising savings relative to investment is the same as increasing exports relative to imports.But this doesn’t necessarily boost economic growth. The total effect of a currency depreciation also depends on how it affects domestic consumption and investment.Here is where things become more complicated. In developing countries with trade deficits, by definition domestic investment is constrained by scarce savings, and so a depreciation, by boosting domestic saving, can boost investment. This in turn raises the growth rate of the economy. It is why most analysts assume automatically that developing-country currency depreciations boost economic growth rates.But this is only true in deficit countries, which China isn’t. It is a surplus country, which means domestic savings in China exceed domestic investment. In fact, China actually suffers from an excess of domestic savings, and Beijing has been trying for over a decade, with limited success, to boost the consumption share of GDP and reduce the savings share.The point is that because Chinese savings already exceed investment, unlike in a deficit country, the increase in Chinese savings caused by a renminbi depreciation will not result in more investment.That is why in China’s case, depreciating the renminbi will not boost growth. It will simply reduce further the household share of GDP which, in turn, will further reduce the already-low consumption share in favour of more savings. For a country overly reliant on its trade surplus for growth, and struggling with a weak and declining consumption share, this would be going in the wrong direction.But if that’s the case, why has the PBoC been so reluctant in the past two years to allow the renminbi to surge in international markets? Wouldn’t a much stronger currency, by effectively transferring income from manufactures to households, help rebalance domestic demand in the way Beijing has wanted for over a decade?The problem is that while a strengthening currency will indeed increase the household income share of GDP and reduce the business share, it can do so in ways consistent either with an expansion of growth or a contraction. In the former case, if the currency strengthens in a gradual and non-disruptive way, the increase in consumption will outpace the reduction in net exports, and so total demand for manufacturing will increase even as export growth declines.In the latter case, if the currency strengthens too quickly and disruptively, enough exporters could become insolvent to cause a contraction in exports, which in turn would cause a rise in unemployment. In that case consumption would actually decline, but production would decline faster (and unemployed workers lose savings), so that while China would still rebalance, it would do so through a contraction of the economy.The point is that as a persistent surplus country, changes in the value of its currency affect China very differently than it does persistent deficit countries. A deeply unbalanced Chinese economy benefits from a steadily appreciating currency because, as the PBoC has pointed out many times, this helps drive rebalancing and reduce excess savings.The reverse is also true. While a depreciating renminbi would almost certainly boost exports, it would cause the consumption share of GDP to decline even faster than it has in the past two years by reducing the real value of household income. That is why the ideal position for China is a gradual, steady increase in the value of the renminbi that promotes rebalancing. Unlike with a deficit country, depreciation will not boost Chinese growth. More
