The Downside of Devaluation

In a piece in the next issue of The Economist, Brad Setser nicely explains the risks of a potential yuan revaluation against the dollar:

According to Brad Setser, a former Treasury official now at the University of Oxford, a dearer yuan would have a more significant effect on capital flows. At the moment, foreign capital is finding its way into China in anticipation of a yuan revaluation. Speculators want to be holding Chinese assets when the currency in which they are denominated jumps in value. The PBoC soaks up this foreign money and recycles large portions of it back into American Treasuries. Once the long-anticipated revaluation actually occurs, the speculation will ebb, and the PBoC will find itself with less money to throw at American assets. As a result, the price of those assets will fall and American interest rates will rise, encouraging Americans to live within their means.

Revaluing the yuan will have little impact on the US’s trade deficit, which is fundamentally the result of the US consuming more than it produces. But I agree with Brad that it will have a substantial impact on asset market prices, in particular the bond market. Of course, asset market prices matter to the output markets, too… imagine some of the possible consequences if long-term interest rates rise by a point or two in a short period of time. It’s a needed adjustment, and probably an inevitable adjustment, but it won’t be painless.