Andy Xie Warns of Yuan Devaluation

The Second Leg Down
China's exports are likely to rise at 10 percent or less for the foreseeable future. This means that the money supply will eventually fall below 10 percent too. As money becomes scarcer, it is a bad mistake to put more into supporting the bubble. There isn't much left to support restructuring or rebalancing the economy. The contradiction will trigger an economic collapse.

The argument in favor of supporting the bubble is that the economy is weak and needs help from the bubble. That view is wrong in two ways. First, China has a labor shortage. A weak economy does not endanger social stability. Second, would one pop the bubble in a strong economy? In a strong economy, speculators call the bubble the right pricing for a better future. Hence, there is no bubble to burst. Wavering between the two makes the bubble bigger and bigger. This is why China's bubble is so big now. Delaying action merely takes the economy closer to a collapse.

I'm not sure that the policy support for the bubble will work this time. The global environment is different. No emerging market can run a bubble in an environment of tightening global liquidity. Further, China's domestic savings have a lower home bias than in most emerging economies. When the wind changes direction, foreign hot money and local money alike could move into foreign currencies. The pull effect from higher interest rates offshore may be too strong for domestic policies to offset.

Letting go now is better than waiting for a collapse. China should increase interest rates as soon as possible. It is necessary to sustain yuan stability in today's global environment. The alternative – devaluing the currency – may trigger panic outflow. It is a worse alternative.

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