Desperate move by China a worrying sign: Don Pittis

The father of Western medicine, Hippocrates, had some advice in 400 BC that has been passed down to today: "Extreme remedies are very appropriate for extreme diseases."

As the world responds to this week's extreme and unexpected devaluation by the Chinese central bank, it sounds as if Beijing was taking the good doctor's advice. And while the obvious intent was to snap the Chinese economy back to health, the frightening thing is that Beijing's move smacks of desperation.

• China devalues yuan amid trade slump
• Loonie and oil plunge as world adjusts to Chinese devaluation

The modern equivalent of that Hippocratic maxim is: "Desperate times call for desperate measures." As the Chinese currency and world markets took a dive, investors and trade partners around the world were asking themselves: "What does Beijing know that we don't?"

It's not the first time this year that China has used strong government action to try to counteract inimical market forces. This spring, Beijing intervened, once to encourage stock markets to inflate, and then repeatedly in an attempt to stop the irresistible plunge when savvy traders realized stocks had become unrealistically high. 

• Asian markets plunge despite measures to halt China meltdown
• China's reminder that markets are never risk-free

The trouble is that markets do not like wild swings. And an economy that requires repeated radical intervention is one, like Russia, where no one knows what the government might do next.

Until recently, the fact that China was willing to back its own economy made it seem like a giant island of stability in a volatile world. In the darkest days of the great recession after 2007, China pumped money into its economy by encouraging borrowing and keeping the renminbi undervalued. (The renminbi is the official name of the Chinese currency, meaning "the people's currency." Yuan is the name of a unit of the renminbi.)

The worldwide demand for commodities soared as it seemed China's building boom would never get enough copper or iron. Its thirst for oil seemed unquenchable. The Chinese currency began to strengthen.

• The astounding rise of China's currency

But now all that has changed. China has become worried that its companies and citizens may have borrowed too much, pushing property prices into the stratosphere. Now it says its currency is too high.

With this latest intervention, rather than making markets cheer, commodities slumped even further. Oil, which for a while this week seemed to be recovering again, hit fresh lows for the year. World markets fell, with the Dow and TSX facing triple- or double-digit declines on Tuesday. Canada's loonie fell.

Part of the trouble this time is that consciously resetting your currency is a zero sum game. A cheaper Chinese yuan makes the country's exports cheaper. But it hurts all of China's trade partners and competitors. And there are ways for partners and competitors to retaliate, raising fears of a new currency war.

• Falling loonie part of a new race to the bottom

After years of growth, China's economy is bigger than all other countries except for the U.S. No wonder its action comes as a shock to the entire world economy. There are serious concerns the sudden move could spark a new global round of deflation.

As its stature grew and Beijing adopted the institutions of a market economy, the world assumed China would try to become a stabilizing global force. The latest move may mean China is not ready for that role.

Sophisticated advice

And the effect is not just on governments. In the world of trade, where profit margins are narrow and deals are made months in advance, a two per cent shift in currency is enough to take a company from profit to loss.

Beijing justified the currency shift by saying that it wants the free market to have greater influence in setting the price of the renminbi. Since China's central bank sets a limit of a two per cent change in the value of the currency on any trading day, if Beijing is serious about letting the market set currency prices, the plunge may not be over yet.

Most worrying is that China's leaders have access to some very sophisticated advice. Swarming with internationally trained economists, the central bank and finance ministry certainly realized the impact of this move. They went ahead anyway.

China's leaders have repeatedly said the economy remains healthy, if "sluggish." But now this may show they're worried something worse is happening.

That is important because economists and political analysts have repeatedly said that while Chinese people may be dissatisfied with many things in the country, high growth rates have kept dissent under control. 

This week, even before China's currency move, the San Francisco branch of the U.S. central bank issued a report titled Is China's Growth Miracle Over?, warning the Asian giant may follow the path of the smaller Asian Tigers — economies like those in South Korea or Taiwan — into lower growth.   

"With an aging population, slowing productivity growth and the policy adjustments required to implement structural reforms, growth is projected to slow further," says the report's author Zheng Liu.

And while it would be wonderful if China can indeed follow the path of Japan and South Korea into middle class stability, it is not clear the way will be easy. Expect more remedies. 

Follow Don on Twitter @don_pittis

​More analysis by Don Pittis