Chinese devaluation is a bigger danger than Fed rate rises

The yuan has fallen to the lowest in five years against the dollar. If China devalues in earnest, it will be an earthquake. 

The greater risk for the world over coming months is that China stops trying to hold the line against devaluation, and sends a wave of corrosive deflation through the global economy. 

Fear that China may join the world's currency wars is what haunts the elite banks and funds in London. It is why there has been such a neuralgic response to the move this week to let the yuan slip to a five-year low of 6.4260 against the dollar. 

Lest we forget, China's fixed capital investment has reached $5 trillion a year, as much as in North America and Europe combined. The excess capacity is cosmic. 

Pressures on China are clearly building up. Capital outflows reached a record $113bn in November. Capital Economics says the central bank (PBOC) probably burned through $57bn of foreign reserves that month defending the yuan peg. 

What is clear is that China has suffered a major currency shock. The yuan has been strapped to the rocketing dollar through its peg at a time when it needed a weaker exchange rate, and this has been made worse by Japan's devaluation game next door and by crumbling currencies in Russia and East Asia. 

A beggar-thy-neighbour policy would be hard to square with China's ambition to be a stabilizing pillar of the world's economic order, newly annointed as a member of the International Monetary Fund's currency basket (SDR). 

President Xi Jinping is chiefly concerned with harnessing "reforms" to smash rivals, centralize all power in his own hands, and restore the hegemony of the party - and party control is ultimately incompatible with the free market. 

His military and strategic expansion in the South China Sea show that he would not have slightest hesitation in dumping yet more of China's excess capacity on everybody else if he thought it to be in his political interest.

DYI