China chooses deflation
By not devaluing in response to US tariffs, China allows itself to fall into deflation
When someone does something bad to you, you can either react or pretend nothing happened. China’s refusal to devalue the Yuan against the Dollar means it’s doing the latter. This might seem like a smart move in the short run, but it does nothing to alleviate the substantial negative shock US tariffs pose. Goods that would have gone to the US are instead piling up in warehouses or getting transshipped to the US via third countries like Thailand and Vietnam. The scale of these transshipments - they are massive - is one indication of just how severe this deflationary impulse is.
China was on the verge of deflation before US tariffs hit. The left chart above shows headline CPI inflation in the US (blue) and China (black). Headline inflation in China fell below zero towards the end of 2024. US tariffs will only hasten this deflationary dynamic. The right chart shows that core inflation looks little better. The way to counter this deflationary dynamic would be to ease monetary policy, but an inevitable byproduct of such easing is a fall in the Yuan against the Dollar. China doesn’t want that, so it’s - instead - making a choice to accept deflation.
The decision to keep the Yuan stable against the Dollar thus isn’t a get-out-of-jail-free card. It puts a constraint on monetary easing by the PBoC, which in turn means that real interest rates in China will rise. In other words, financial conditions in an economy that’s struggling under the weight of US tariffs will be tightening.
The de facto peg of the Yuan against the Dollar means China is bumping up against the “impossible trinity,” whereby it’s impossible to have independent monetary policy amid an exchange rate peg and capital mobility (China of course has capital controls, but capital flight periodically rears its head). The decision not to devalue against the Dollar therefore has very real, adverse consequences: it makes a fall into deflation much more likely. The fact that the Yuan is falling on a trade-weighted basis doesn’t change this - as I wrote in yesterday’s post - because a trade-weighted fall doesn’t alleviate the adverse shock to China’s economy from US tariffs. Only a bilateral devaluation against the Dollar can do that.
I believe you may be missing the broader context.
In addition to the advantages outlined in my previous note, over the long run, a stronger RMB would likely encourage the Chinese economy to rebalance—shifting away from export-led growth toward more domestic-driven expansion—while inducing a range of structural adjustments. This is precisely what the Beijing government aims to achieve.
An immediate effect of RMB appreciation is an increase in Chinese households’ purchasing power. Imported goods—from food and consumer products to energy and commodities—become relatively cheaper in local currency terms. A stronger yuan boosts real incomes and wages, allowing consumers to buy more with the same nominal income. In other words, a stronger RMB raises living standards by making imports less expensive.
Another key benefit is the rationalization of investment projects, especially those geared toward export expansion. Some of these projects will be scaled back or postponed, as a stronger currency reduces future export profits in RMB terms. Export-oriented manufacturers facing thinner margins may redirect capital from exports to domestic demand, while also boosting productivity.
Lastly, a stronger RMB will force companies to further move up the value-added chain and drive innovation, while simultaneously lowering the cost of intermediary goods.
The “Japanification” analogy is, in my opinion, not especially fitting, as it fails to account for major differences between Japan in the 1980s and China today. The most important differences are:
1) Political systems—Japan was clearly hampered by ineffective and delayed policy intervention.
2) Economic stage—China is at a different point in its development.
3) Demographics—China’s population is much larger and, on average, younger. Combined w/#1 & #2 potentially delaying any similar economic scenario
This is a sharp and insightful take on China’s current dilemma. It highlights the tough balancing act Beijing faces—trying to maintain Yuan stability to project strength and avoid currency war accusations, while simultaneously grappling with the mounting economic pressure from US tariffs.