China’s Lonely Fight Against Deflation

HONG KONG – In early February, as China celebrated the start of the Year of the Monkey, a widely circulated hedge-fund newsletter roiled financial markets by predicting a hard landing for the economy, the collapse of the shadow-banking system, and the devaluation of the renminbi. Stability returned only after People’s Bank of China Governor Zhou Xiaochuan, in an interview with Caixin magazine, explained the logic of China’s exchange-rate policy.

But China’s ability to maintain that stability depends on a multitude of interrelated factors, such as low productivity growth, declining real interest rates, disruptive technologies, excess capacity and debt overhangs, and excess savings. In fact, the current battle over the renminbi’s exchange rate reflects a tension between the interests of the “financial engineers” (such as the managers of dollar-based hedge funds) and the “real engineers” (Chinese policymakers).

Foreign-exchange markets are, in theory, zero-sum games: the buyer’s loss is the seller’s gain, and vice versa. Financial engineers love speculating on these markets, because transaction costs are very low and leveraged naked shorts are allowed, without the need to hedge an underlying asset. The exchange rate, however, is an asset price that has huge economic spillovers, because it affects real trade and direct-investment flows.

Nowadays, financial engineers increasingly shape the exchange rate through financial transactions that may not be linked to economic fundamentals. Because financial markets notoriously overshoot, if the short-sellers win by pushing exchange rates and the real economy into a low-level equilibrium, the losses take the form of investment, jobs, and income. In other words, financial engineers’ gain is real people’s pain.