China is teetering on the brink of a radical policy change that could transform not just China, but also world financial markets.
Current global pressure on emerging markets is felt most acutely in China. In the comparable late 1990s, the Asian crisis largely passed China by. Its hefty devaluation in 1994 had left it highly competitive. The latest upswing of US interest rates will again hit the overvalued emerging markets hardest. This time China is the most exposed.
We calculate that China’s exchange rate is about a third overvalued, measured by relative labour costs. China plunged into producer price deflation two years ago, despite rapid wage inflation. Chinese businesses had to cut prices to hold up sales in world markets. They were already about 10 per cent overvalued. Labour costs have since risen a further 20 per cent versus trading partners. Price deflation means overvaluation is less evident in price terms, but the cost is serious profit-margin shrinkage.