China does not have a problem

Today's breathless China headline: "Chinese Yuan's Drop Is Largest Since Its 2005 Currency Revaluation." Yesterday's headline was even more breathless: "China Currency Plunges Most In Over 5 Years, Biggest Weekly Loss Ever." Reading these headlines, you'd be tempted to think that China was in trouble, but you'd be very wrong.

Here's the "plunge" in the value of the yuan from a big-picture perspective:

That's right, you can barely see the "plunge" when you look at  a long-term history of the yuan. Since its all-time high of 6.04 in mid-January, it has dropped a mere 1.7%, to 6.1415. The big story in China continues to be the yuan's impressive strength, not its weakness: it's up 42% vis a vis the dollar in the past 20 years.

And it's not just the yuan appreciating against the dollar. It has appreciated against every currency in the world, and in inflation-adjusted terms as well. As the chart above shows, the real value of the yuan against a large basket of currencies has appreciated by a staggering 85% in the past 20 years. Only the yen has a better record of long-term appreciation: it rose 250% against the dollar from 1970 through 1994 (from 350 yen per dollar to 100).

Spectacular gains in Chinese productivity—which have boosted the size of China's economy by 8-10% per year for the past 20 years—are the main reason the yuan has appreciated. Capital has poured into China, eager to finance and profit from China's impressive progress.

To accommodate the huge increase in the size of China's economy, the Chinese central bank had to expand the Chinese money supply by orders of magnitude. They did this in a very prudent fashion, by buying almost $4 trillion of the capital inflows that China has received over the years. These purchases provided a solid foundation (in the form of an expansion of China's foreign reserves—see chart above) for a necessary expansion of the amount yuan in circulation. (Think of the growth of China's foreign exchange reserves as a proxy for net capital inflows.) Yet even though it bought trillions of dollars with newly-created yuan, the central bank allowed the yuan to appreciate. In a sense, they didn't buy enough dollars and euros, and that created an effective shortage of yuan which could only be resolved via a yuan appreciation.

But as the chart above also shows, China's accumulation of reserves has slowed down significantly over the past few years. That's because the central bank has liberalized capital flows, and the strong appreciation of the yuan has brought China's costs more into line with costs overseas, with the result that the economy has cooled off. With capital inflows "tapering" off, there is much less pressure for the yuan to appreciate. The central bank is correct in allowing (and even encouraging) the yuan to trade more freely. The yuan was on a one-way street (appreciating) for the past 8-9 years, and that can't go on forever. Looking ahead, it's likely that the yuan will bounce around in a relatively stable channel, rather than constantly appreciating. This new perception alone could help reduce capital inflows and avoid any unnecessary or unwarranted "overheating" of the economy.

For the past 15 years or so, Chinese inflation has been very similar to U.S. inflation, as the chart above shows. But since the yuan appreciated against the dollar by about 37% over this same period, Chinese prices effectively rose by roughly that amount relative to U.S. prices. This has made China somewhat less competitive, and that has worked to slow its growth on the margin. But it's still growing by at least 7% a year. And the central bank still has almost $4 trillion of reserves, which makes the yuan potentially the most rock-solid currency on the planet. What's not to like about a growing economy and a strong currency and low inflation?