> second order effect

The main negative effect is capital flight. If the yuan is devalued, ceteris paribus, an investor holding yuan would prefer to hold anything else. For example, "in 2015, China ...[devalued] the yuan 2%...[and had to burn] through $1 trillion in foreign exchange reserves to steady it" [1][2].

This time might be different, given China's tightened capital controls. But never underestimate peoples' creativity when it comes to moving their money.

[1] https://uk.reuters.com/article/uk-china-markets/china-lets-y...

[3] https://www.bloomberg.com/news/articles/2016-01-25/china-cap...

"If the yuan is devalued, ceteris paribus, an investor holding yuan would prefer to hold anything else."

If you didn't sell your CNY at yesterday's price, why would you want to sell at today's (lower) price?

> If you didn't sell your CNY at yesterday's price, why would you want to sell at today's (lower) price?

Minorly, because tomorrow's price might be lower. Majorly, because even taking into account the price drop, the present value of the currency-swapped yield on investments in a foreign currency are greater than those prospects at home.

On the other hand Chinese goods are now cheaper which should be good for exports and the economy so that would encourage you to want to hold the currency.

That is an economic argument over something that seems to be a political valuation though.

> On the other hand Chinese goods are now cheaper which should be good for exports and the economy so that would encourage you to want to hold the currency.

That doesn't make sense. Holding a currency that gets devalued (and you believe it will be devalued further in the future) doesn't benefit from an improvement in the underlying economy. I.e. if I own 100 yuan, which buys about 14.25 dollars, if the currency is devalued so that in one year it only buys 10 dollars, even if that devaluation caused Chinese exporters to do great, I still would have done much better if I switched over to dollars originally. Currency doesn't pay a dividend.

Disagree. This totally makes sense.

Yesterday people in America were buying TV's from people in China. Let's say the price of a given TV was $140.

Now that the CNY/CNH is 'lower' (in the sense that you now need more than 7 CNH to buy $1), the price of those TVs just fell.

Now maybe the price of the TV's at $140 was in some contract, but the next time the contract comes up for review, the lower CNY reflects the fact that someone in China will accept 'less' for their TV than they were yesterday.

Extend this logic from a 1% move to a 20%.

As prices fall, maybe people start buying more of their TVs from China than South Korea, cause relative to the price of TVs from SK, the Chinese TVs are now a 20% discount.

~~~

Now, whether a falling FX makes for greater or lesser demand for Chinese financial assets, that's a different story. Would expect this to prompt capital flight.

~~~

And finally, yes, currency does pay a dividend. Just usually in the form of a different interest rate. So for 'lending' to a developing currency (in the form of buying a financial instrument or holding a bank account), you generally earn the local interest rate.

When capital deems that country as more risky, then that is reflected in the yield of short term interest rates. Were you to lend to Brazil, you might want 1,2 or even 5% more than you get for lending to JP Morgan or the US Govt.

Now, the fact that this 'interest rate spread' doesn't really exist vis-a-vis China, well that's the whole issue at stake. If interest rates in China are too low, then you would expect people to want to exchange their CNY for USD, since why not put it in dollars if it doesn't cost you much. Again, hence capital controls to protect against capital flight.

Macro folks call it the 'trilemma' and we're seeing a real time experiment in it, on a massive scale, right here.

https://www.investopedia.com/terms/t/trilemma.asp

The whole first part of your post, though, still doesn't affect someone who owns actual currency, e.g. money in a bank account, as opposed to assets (e.g. shares in a Chinese exporter), which is what I was responding to. If that Chinese TV exporter ends up doing great because of devaluation, that doesn't benefit you if you just have actual yuan.

It depends at what level you want to look at it. If the economies doing well your money is more likely to find productive investments, alternatively the central bank could increase interest rates to regulate the economy, both would be good for you personally as well as tending to push rates up.

My greater point was that exchange rates tend to be self regulating (in this situation), you'd expect it to return to mean rather than get stuck in a feed back loop. This is China though so I have no idea how much they need to heed economic reality.

Sure, and therein lies the difference in incentives between those with lots of CNY denominated assets (owners, aka the rich) and those who's employment and/or income is more tied directly to the demand conditions faced by exporters (workers, aka the poor).

Once the 7 line is crossed, owners are more likely to seek diversification through getting out of CNY and into USD/Gold.

Some of that downward pressure on the FX is likely good for demand in China (hence Trump saying they are doing it competitively) but it's also bad for liquidity in China (to the degree people start to price in further devaluations and capital flight kicks up again).

That's the balancing act the PBOC is trying to manage.

Thusfar they've done a pretty good job balancing, though it remains to be seen how the end game looks.

That's not how this works.

The first point violates your explicit 'ceteris paribus' assumption. A devaluation today doesn't on its own provide information about future moves.

I don't understand your second point. Perhaps you could give a simple illustration?

> The first point violates your explicit 'ceteris paribus' assumption.

Not necessarily. The decision of individuals to allocate in a particular manner can be thought of as a continuous function (IIRC this is called an indifference curve). In this case, the individual’s preferences (given by this curve) remain constant. As the relative prices of goods (currency being one) adjust, the composition of the preferred basket also adjusts. This is consistent with ceteris paribus. If an individual’s preferences were assumed to change, then the assumption would be violated.

> A devaluation today doesn't on its own provide information about future moves.

In general terms, people cite ‘momentum’ as a trading factor. A change in price today may continue tomorrow. If you consider the feedback loops that occur as something appreciates or depreciates, it may explain why momentum can be observed.

In more concrete terms, China has very deliberately kept its currency from devaluing below this level against the dollar for quite some time. The country has attempted to undermine short positions against the currency by doing things like adjusting fixings and overnight rates massively against the shorts for a brief period. Given that China is now allowing this devaluation to occur, it signals that the nation has a new exchange target in mind, presumably lower than the previous one.

Current decisions are made on expectations of what happens in the future, not on what actually happens in the future. Expectations may change immediately based on the flimsiest of reasons. Here it could be the preception of change in government policy.

Also 'all else being same' assumptions are just an explanatory tools for showing effect of basic economic principles (like supply/demand) within economy, not something to be taken too rigidly. There's no such thing as 'all else being same' in reality.

What? No it doesn't violate it at all.

Because it may go lower.

Capital flight happens when you think the yuan is going to lose more value, not when it has already lost value (too late). For example, I got most of my money out of RMB in 2016 when it hit 6.4 in one swoop, since I thought it would go 7 quickly (I was wrong, but there was no reason to not have USD anyways as a foreigner).

Chinese could also convert $50k a year for their own needs without having to justify it. (Foreigners could convert however much they made), so the controls were pretty reasonable at that time, not sure how it is now.

> Capital flight happens when you think the yuan is going to lose more value, not when it has already lost value

Rule of thumb in finance. When a system that looks stable assuming rational actors has a history of going haywire, the answer is usually leverage.

Devaluations spin out of control because of foreign-currency borrowing. Dollar debtors paid in yuan become forced sellers of assets and yuan amidst devaluation. (Their interest payments, in yuan, go up. Their revenues, in yuan, do not.) This panicked selling further devalues the currency, which leads to more panicked selling. This is a currency crisis.

When a government communicates FX boundaries, borrowers see a risk limit. They might hedge against currency moves up to that limit. Or keep enough dollars on hand (via cash or credit lines) to absorb pain up to that limit. Either way, when that limit is breached, they bleed. This feedback mechanism is commonly known, which turns breached limits into a self-fulfilling prophecy.

Confidence is tricky.

China is a bit weird, they have the option of devaluing in a big chunk, eg that drop in 2016. These days the yuan is more market driven and efforts to manipulate it are indirect via dollar trading and interest rates. However, those bigs changes are lot more scarier than smaller movements with moments.

7 was considered a line in the sand that the government wouldn’t cross. Now that they crossed it, no one knows where the line in the sand is.

The conversion is much much harder starting this year, subject to full review from both side of the government. That might also contributed to why US 1.5M+ “mansion” prices are dropping rapidly

Housing is in a huge bubble on both sides of the pacific, the removal of Chinese money could push the USA over the edge like it did via Japan in the late 80s/90s.

What is the effect of any on the desire of making the yuan an international reserve currency?

Will (foreign) holders of Yuan just shrug or will it lead to more caution, do they have a choice?

> If the yuan is devalued, ceteris paribus, an investor holding yuan would prefer to hold anything else.

AUDUSD dropped almost 40% since 2011 and it is keep doing down, according to your theory, there should be any investor holding AUD.

2015 capital outflows was basically fake news lol.

It also counters the import tariff tax lessening the price increase on consumers who seem to be the main constituency of pundits.

Which plays towards the “and China is going to pay for it” rhetoric.

The cost of tariffs is always split between suppliers and consumers, roughly in proportion to the elasticity of demand.

I agree that that is typically true, but in the particular case of the 2018 tariffs on China, the cost pretty much fell entirely on consumers.

> Overall, using standard economic methods, we find that the full incidence of the tariff falls on domestic consumers, with a reduction in U.S. real income of $1.4 billion per month by the end of 2018

> We find that the U.S. tariffs were almost completely passed through into U.S. domestic prices

https://www.nber.org/papers/w25672.pdf

Thanks for the link! It looks like initially the price spikes by pretty much the tariff rate, and then over the following months returns back in line with the long term trend line.

This makes sense because we also see a significant reduction in import volume from of the goods being taxed, so it implies producers are finding alternate suppliers to avoid the China-specific tariffs at close to the China-supplier price.

> The cost of tariffs is always split between suppliers and consumers, roughly in proportion to the elasticity of demand.

The trick is there. It's possible to have China paying for all the tariffs or the other way around. It's probably going to be more complex though: Different products, currency fluctuations and possible rise of other markets.

Yeah, but it also knocks down oil and other commodity prices that constitute a large portion of Chinese imports.