Can China Make Currency Markets Behave?

If you own a business in an environment with many competitors that sells some generic good, say bananas, could you gain business by reducing your prices?  The answer is maybe.

You could do so in the short run.  Once the short run passes, one of two things will have occurred.  You will no longer be in business, or your competitors will have lowered their prices to match.

If you have reduced your price because you have made some productivity gain, then possibly you can retain your new customers after your competitors lower their price and then fail.  Absent the structural advantage, price reductions accomplish little.

It is not so different on the international scale.  Some countries think they can reduce the prices for their goods and services by devaluing their currency.  Countries that allow the market to set their exchange rates will usually change based upon some factor in their economy.  In Canada the dollar has fallen about 25% because of world prices for natural resources, principally oil.  Outside of the resource industries, businesses that import goods or components for what they manufacture are injured and exporters rewarded.

Some countries establish an exchange rate that is not dependent on market forces.  They use their central bank and its reserves to create artificial supply or demand for their currency and affect its price to be what they wish it to be.  The most recent example is China’s 2% reduction on 11 August.

The Chinese government’s hope to spur their economy by making their goods a little cheaper in US Dollar terms.  At the same time imports will be a little more expensive and that may add domestic sales where there are local replacement goods available.

It will work if and only if:

  1. They have enough currency reserves to support their market intrusion
  2. No one else, in particular the US, allows their currency to devalue
  3. The devaluation is enough to get the intended consequence
  4. The intended consequence happens fairly quickly

Governments such as China believe they can overwhelm the market by force of will.  Many find that it doesn’t work.  It does not work in a world where your adversaries match to neutralize the harm to their own economies.

Should we worry?  Maybe.  The thing to be alert for is the response to the devaluation and the next steps taken in China to counter that move.  What we should not want is a currency war.

A currency war generates many unintended consequences because it is, in its simplest form, a race to the bottom.  It is a chaotic time for anyone involved.  People do not know what their money is worth.  How hard would it be to operate a fabric store if the size of a meter was unknown and changing?  Same thing with money changing its value.   How much should an iPhone sell for when the unit of exchange is a variable.

Perhaps governments should listen to an Indian proverb prior to participating in such a war.

“It is easier to ride a tiger than to get off.”

 

Subscribe to the daily MoneyFYI article at moneyfyi.wordpress.com, Follow on Twitter @DonShaughnessy or Contact: don@moneyfyi.com  

Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

This entry was posted in Personal Finance and tagged , , , . Bookmark the permalink.

3 Responses to Can China Make Currency Markets Behave?

  1. Wilfred Wei says:

    Don, thank you for another great post. The irony is that the Indian proverb you quoted, is traced back to a well documented Chinese origin, which the Chinese policy makers are well aware of:
    The Chinese expression “騎虎難下” (qí hǔ nán xià), literally “riding a tiger and it being hard to get off of,” is used to describe a situation in which one is stuck in a difficult position with no way out.
    This idiom is based on a story about Wen Jiao from the Book of Jin, which is an official text covering the history of the Jin Dynasty from A.D. 265 to 420.
    There is an opinion that the Chinese policy makers are forced into this situation, despite knowing some of the potential consequences:
    http://www.theguardian.com/business/2015/aug/11/china-devalues-yuan-against-us-dollar-explainer

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s