China Devalues – Euro Zone’s QE Policy Hits a Wall

by Dirk Ehnts, Econoblog101

Whatever the words from the ECB, quantitative easing was all about lowering the exchange rate of the euro. Why? Because aggregate demand falls short in the euro zone, way short.

With 11% unemployment – now rising again – and an increase in government spending taboo, mostly because of German policy makers not understanding the fundamental importance of the role of demand, government spending and the monetary circuit, Draghi has tried to provide some help in the form of a lower euro exchange rate.

He also proved that the ECB buying up sovereign bonds does not lead to hyperinflation, by the way.

And, as I have commented before, the euro zone is too big to be able to devalue itself out of a demand problem.

So, it was no surprise that China – which fixes its RMB against the USD – started to experience problems. A weaker euro is a stronger dollar and therefore a stronger yuan, as Bloomberg reported three days ago:

China’s exports declined more than expected in July, hobbled by a strong yuan and lower demand in the European Union, and adding pressure on Premier Li Keqiang to stabilize growth.

Overseas shipments fell 8.3 percent from a year earlier in dollar terms, the customs administration said. The reading was well below the estimate for a 1.5 percent decline in a Bloomberg survey and compared with an increase of 2.8 percent in June. Imports dropped 8.1 percent, widening from a 6.6 percent decrease in June, leaving a trade surplus of $43 billion. It came despite a few bright spots, including the highest monthly steel exports since January.

The Chinese authorities reacted today and devalued the RMB by 2% against the USD, The New Yor Times reports:

The central bank set the official value of the renminbi nearly 2 percent weaker against the dollar. The devaluation is the largest since China’s modern exchange-rate system was introduced at the start of 1994.

China’s abrupt devaluation is the clearest sign yet of mounting concern in Beijing that the country could fall short of its goal of roughly 7 percent economic growth this year.

The euro zone, by trying to beggar their neighbors – US and China, which form a dollar zone that has been doing much better than the euro zone – has triggered a currency war. In a world economy with insufficient demand, all countries try to secure market shares for their exporters by lowering the nominal exchange rate. This, obviously, is a zero sum game, so countries only gain if other countries do not react to devaluation with a subsequent devaluation of their own currency.

Since governments that care for their people in terms of employment will not let unemployment rise just because another country decided to devalue its currency, this strategy often fails. Especially so if there is no formal or informal agreement. The current non-system of global monetary matters now comes back to haunt us. Some exchange rate coordination would surely be preferable to a full-blown currency war. It will be interesting to listen to the comments following today’s policy change.