China IS fixing its economy

Once again, China's attempt to devalue the yuan has been greeted with sheer market panic. Lacking better economic data, markets interpret the devaluation of the yuan as an implicit acknowledgement by the Chinese government that the country is headed into a downturn.

There is, however, a simpler and less malignant interpretation, and one that deserves a hearing: China is fixing an earlier policy mistake, and that's good news.

In the summer of 2014, when oil prices tanked, every major U.S. trading partner—bar China—devalued against the dollar. Quite often, a strong dollar is brought about by global economic weakness. If investors are worried about a recession, they seek refuge in the dollar and U.S. government securities. This time, however, the dollar rallied due to the strength of the U.S. economy, specifically, the effect of shale oil production on U.S. terms of trade.

Shale oil production has transformed the U.S. current account. The U.S. trade deficit in oil has shrunk dramatically, from $30 billion per month from the dawn of the shale revolution in early 2012, to a mere $6 billion recently. On an annual basis, the trade deficit reduction is more than $300 billion, almost 2 percent of GDP.

This, in turn, has supported a strong dollar, made even stronger with the collapse in the price of U.S. oil imports in late summer 2014. In response, America's key trading partners—the euro zone, Japan and South Korea—all devalued their currencies against the dollar. The euro, for example, has fallen by one-fifth against the dollar in the last 18 months.

Not so the yuan. The yuan remained pegged to the dollar and implicitly followed the dollar up. In dollar terms, the yuan was unchanged. In euro or yen terms, the yuan has appreciated dramatically. This has predictably tanked China's export and manufacturing sector.

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The People's Bank of China tried to remedy this with a small but sharp devaluation last August, which prompted fears of Chinese Armageddon, in turn causing the People's Bank to suspend further devaluations. Of course, the yuan remained materially overvalued, with continued capital outflows and persistent export weakness the result.

The People's Bank resumed devaluations — minute, daily devaluations — in December on the hopes that no one would notice. Well, investors noticed and once again capital markets are consumed with the prospects of a Chinese meltdown.

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While China's economy may implode, the simple, plain vanilla explanation sees a yuan in need of realignment. This is not the End of Days, but the fixing of an earlier policy mistake. When the yen and won devalued against the dollar, no one was saying that Korea or Japan were finished.

If China had a floating exchange rate, the yuan would have devalued with won and yen, and no one would have given it a thought. In a fixed exchange regime, however, policy mistakes become magnified. A devaluation is filled with meaning. Be that as it may, the primary interpretation of a Chinese devaluation, at this point, is the correction of an earlier problem, not the end of Chinese civilization as we know it.

So let's give Beijing and the People's Bank of China a break. If an overvalued yuan is the problem, then devaluation may well put the country back on course. I would estimate that there is a one-in-two chance that devaluation will do the trick, for number of reasons.

First, analysis by the Bank of England, as well as by University of California, San Diego economist James Hamilton, has noted that 60 percent of the weakness in oil prices can be attributed to weak demand. But this weak demand arose at exactly the same time the oil supply surged, the oil price tanked and the dollar soared.

The only readily identifiable, demand-side event occurring simultaneously was the failure of China to devalue the yuan. Put another way, if models are correct, then an over-valued yuan is quite likely the cause of global commodity price weakness. It was not a weak global economy; it was China's exchange rate.

Second, the Chinese domestic economy does not appear to be in such bad shape. Year on year, auto sales in November were up a whopping 24 percent, and gasoline consumption was up 9 percent. We rarely see such numbers in an economic downturn, suggesting that China's problems are sectoral, not endemic.

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Third, manufacturing economies rarely collapse when commodity prices fall. China is the leading importer of the broad range of commodities. The oil supply surge of 2014 should have proved a boon to the Chinese economy. By no means should it have prompted a downturn. And yet, China has struggled, leading us to believe that some other factor — in this case, an over-valued yuan — was probably to blame.

Taking it all together, a meaningful devaluation may well turn around China's economy. Investors need to let the People's Bank of China take a breath and finish the job.

As for the Chinese, this is my advice: Don't tarry. Pick a number, and finish the devaluation in days to weeks, not weeks to months. A devaluation of 6 percent, to 7.0 CNY/USD, should be sufficient to re-align the yuan with regional currencies. But whatever number the People's Bank of China targets, get there with purpose and speed. Markets will not reward indecision.

Commentary by Steven Kopits, managing director, Princeton Energy Advisors.

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