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Today’s big financial news story was the record daily plunge in China’s main stock market – the Shanghai exchange. (I know the term “market” is a complete misnomer for an arrangement so thoroughly controlled by the government; I just use it as shorthand.) Those who follow such matters know that this latest nosedive is prolonging a vicious bear market Chinese stocks that began in early July, and that could have knock-on effects throughout the world economy in forms ranging from continued downward pressure on raw materials prices, to strengthened overall deflationary forces (which are a major threat to global recovery), to severely damaged prospects for Apple Computer. (This longtime U.S. stock market winner has become ever more dependent on booming sales in China and, just as important, its share prices are ever more dependent on perceived chances of more of the same.)

So clearly, both investors and economists understand that China’s stock market woes will reverberate far beyond China – whether they greatly slow down China’s growth rate or not. I’d like to add one more impact – on China’s plans to internationalize its currency, which greatly affect the yuan’s value and, in turn, U.S.-China trade flows and the fortunes of American manufacturing. And anything that affects a portion of America’s productive economy as important as manufacturing is bound to affect its chances for sustainable prosperity.

One of the biggest challenges facing China’s leaders today is reconciling two goals that at least in the short run seem mutually exclusive. The first is that internationalization of the yuan. This would be a difficult objective even in the best of circumstances for China. The benefits would be considerable: A currency widely used by the rest of the world in trade and other commercial transactions, and even better, one awarded reserve currency status by the International Monetary Fund, would be a currency that would increase China’s monetary and therefore economic independence.

No longer would China’s own price levels, competitiveness, inflation rates, growth rates, and attractiveness to domestic and foreign capital depend so significantly on the whims of central banks from today’s reserve currency countries, and especially the U.S. Federal Reserve. Indeed, China’s own monetary policy could influence over other countries’ economies to a degree. Just as important, reserve currency status would reinforce the idea that China had genuinely arrived as a global power – a status reportedly highly valued by Beijing.

At the same time, these benefits still lie very far in the future, since although the yuan’s use in international business is rising rapidly, it’s still at very low levels. One big reason is that neither Chinese nor foreigners are very free to trade China’s currency, though exchange and trading controls have eased a bit in recent years.

Meanwhile, the yuan internationalization drive is already exacting costs. The small degree of liberalization that has occurred reduced the Chinese government’s once-absolute control of its own financial system – meaning its ability to determine how resources are invested. For an economy that’s still dominated by the state, that’s a big deal.

In addition, because China’s version of a central bank in particular seems to realize that a globally used currency needs to be tradeable, and reportedly views it as an aid to broader financial reform, it has allowed the yuan’s value to rise to levels much closer to those that would be deemed appropriate by market forces – at least judging from the yuan trading markets that have sprung up outside China in recent years. As a result, Chinese goods have lost some price competitiveness in China and other markets against goods made by most rivals – including the United States. For an economy whose growth and job-creation still rely heavily on exports, that’s a big deal, too.

Adding to these yuan internationalization problems – these are not the best of times for China. Far more important than the stock market plunge is a growth slowdown that is widely thought to be more dramatic even than the one revealed by official Chinese economic data. And yet the stock meltdown could turn into another big drag on the broader economy if it begins to undermine the confidence of consumers and businesses, and if it starts creating political turmoil by puncturing the aura of economic competence that’s been at the heart of the government’s perceived legitimacy.

Although the Chinese regime’s future is hardly resting on a knife-edge, any lengthy period of subpar growth – and any lengthy pause in the rise of Chinese living standards – could confront China’s leaders with the kinds of tests they’re not used to taking. That’s why I suspect that if push comes to shove, and the economic falters sufficiently, even a regime representing a culture known for thinking and planning long term will suspend the internationalization campaign and start encouraging yuan weakening again. Indeed, Beijing followed precisely this course during the mid-1990s. The conventional wisdom believes that meaningful devaluation is no longer possible, since it would speed up capital flight that appears already to be unprecedented. But I don’t believe that Beijing would hesitate for a moment to reestablish tight capital controls in response. 

Of course, this kind of Chinese currency gambit would work even in a slow-growing world, by enabling artificially cheap Chinese products to boost their share of foreign markets, and help China expand at the expense of its trade partners. Yuan weakening will fail if the rest of the world, especially the United States, pushes back. President Obama seems an unlikely candidate to lead or even participate in this charge. His administration’s view, as made clear in the debate over fast track trade authority and his Pacific Rim trade deal, is that largely because China (a prospective member) has let the yuan strengthen, no measures are needed in trade agreements to ban the practice. As a result, unless and until Congress changes its mind on the issue, Americans will need to hope that Mr. Obama is right that past won’t be prologue.

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