It's Much Worse Than 1997

FT Alphaville: If something can’t go on forever, it won’t, China’s FX policy edition

There are no good options for China, but I maintain that a large one-off devaluation is the best choice since it ends the depreciation of the currency immediately. Unfortunately, the CCP's heavy handed role in the market makes it a scapegoat for anything that happens. As GaveKal points out in the link above:

China’s leaders have repeatedly rejected the notion of competitive devaluation, so a large one-off depreciation would be a diplomatic disaster, wrecking Beijing’s currency credibility.

A normal country facing this situation has an out: allow some chaos into the markets, then do a major one-off devaluation to stabilize the market. The devaluation goes from "beggar thy neighbor" to "market rescue." I'm not sure this option is open to China, at least not without spending something on the order of $1 trillion in reserves.

Whatever happens, the odds of a major dislocation in the financial markets are high and rising. Putting aside the economic and financial market case for this being better or worse than 1997, there's two factors that argue for a far worse situation than 1997: politics and size. The latter first: there will be no bailout for China if only because the numbers are simply too large. Politically, there's unlikely to be agreement about what to do. China will be blamed for causing the crisis. China will at least blame America and Japan, if not everyone in the South China Sea dispute.

As I wrote in 2014: The Logic of Strategy: Yuan Devaluation and the Road to Trade War

The protectionists are ever so slowly gaining the upper hand thanks in part to negative social mood. 2008-2009 will probably mark the peak moment for Wall Street and the Treasury Department, even though there is as yet no sign of it in Washington. Changes can be seen in the form of issues such as immigration, which has turned the grassroots of the conservative movement against the Chamber of Commerce and large corporations (due to an attack initiated by the latter against the former). This has pushed the Overton window of acceptable debate among conservatives who can now take shots at big business. There is also the growing libertarian faction pulled together by Ron Paul that supports his son, Rand Paul, that consistently attacks the Federal Reserve and Wall Street. Put it together and it is not hard to envision an anti-Wall Street, pro-manufacturing political consensus emerging. This will cut across party lines, with manufacturing unions pulling in Democratic support if there are specific bills to vote on.

We have a name for this now: Trump.

I see no reason to adjust what I wrote here:

With a growing economic case against free trade, a shift in social mood making anti-free trade opinion more popular, plus the loss of political support for the financial sector, free trade will become a centerpiece issue in American politics. The trigger will be one of two factors. One is economic. China's credit bubble isn't going to slowly ride off into the sunset. There will be pain, it is only a matter of where it lands. The path of least resistance is devaluation of the yuan, something I have been looking for here for several years now due to the growth in credit. A target of ￥8 to $1 is a reasonable ballpark figure, with ￥10 to 1 not unbelievable given the rise of the shadow banking sector. The actual number isn't as important as the size of the devaluation: it will likely be large and set off the anti-China arguments that have been growing in the United States.

Anti-free trade arguments will quickly take on geopolitical importance:

The second factor is geopolitical. Do take the time to read the lengthy review linked above, and/or watch the video. Luttwak's main point is that China cannot simultaneously build up its economy and influence at the same time it builds up its military, and not run into resistance from surrounding states. He cites the Chinese policy on the island disputes as the case in point: instead of increasing China's power in the region, it has pushed Vietnam, the Philippines, Japan and Indonesia into the arms of the United States. An anti-China coalition is building up due to each nation following the logic of China's inevitable rise in power along with the perception of an increasingly aggressive China. China has "tipped its hand" so to speak and these nations are moving preemptively. Due to the nuclear arsenal of the United States and China (to say nothing of Russia's interest in the region), there isn't going to be a major war for survival. This reduces the options for confrontation, with one of the most powerful being economic. If there is a minor military confrontation that is too large to be ignored, the most politically acceptable response will be economic.

Either the economic or the geopolitical event can happen first then, but in time, the two will be seen as inseparable. Once events move in this direction, the logic to continue down the path is compelling.

The conclusion:

Yuan devaluation is inevitable as soon as China enters a serious financial crisis. If the government refused to devalue, the nation would go through a 1930s style deflationary Great Depression. China is unlikely to allow the market to take the yuan lower in a panic collapse like a replay of 1997. At some point, it would announce a large devaluation designed to end the selling and the crisis. This will be called a political act in the United States (those who understand the economics will nonetheless spot the political opportunity) and the political push for protectionist policies will be too attractive to be ignored. The United States will retaliate with sanctions and the world will follow. This will put even more pressure on the Chinese economy and lead to a massive rise in nationalist sentiment (either that or anti-CCP sentiment, so expect the CCP to redirect it into nationalism). A chill wind will blow across the Pacific that will last a generation or more.

National Interest: The Real Threat of Chinese Nationalism
Bloomberg: As Markets Fall, Nationalism Rises
The Diplomat: Philippine Nationalism and the South China Sea

For that reason, it comes as no surprise that the judicial confrontation between China and the Philippines has been a godsend for revitalizing Filipino nationalism. Echoing this sentiment, Zachary Abuza, an independent analyst who writes extensively about Southeast Asian affairs, asserts that “Chinese aggression is very good for the Philippines,” and has “done more to galvanize Philippine nationalism than anything in the past few years.”

Nationalism is rising and it will keep rising. Asia is the most concerning region because the nationalism there is more xenophobic. Europeans and Americans want to deport foreigners. Misters Trump and Farage talk about getting better trade deals, but if there is any hated, it is aimed squarely at the politicians and media within the country. Not so in China, where decades of anti-Japanese propaganda has turned young Chinese into raging anti-Japan activists. No generation of Chinese outside of the war hates Japan as much as today's young people do. Westerners will express their anger at the ballot box and punish the rich and powerful. In Asia, aggression will be directed abroad.