China's lonely fight against deflation risk

In early February, as China celebrated the start of the Year of the Monkey, a widely circulated hedge fund newsletter roiled financial markets by predicting a hard landing for the economy, the collapse of the "shadow-banking" system and the devaluation of the yuan. Stability returned only after People's Bank of China Governor Zhou Xiaochuan, in an interview with Caixin magazine, explained the logic of China's exchange-rate policy.

But China's ability to maintain that stability depends on a multitude of interrelated factors, such as low productivity growth, declining real interest rates, disruptive technologies, excess capacity and debt overhangs, and excess savings. In fact, the current battle over the yuan's exchange rate reflects a tension between the interests of the "financial engineers" (such as the managers of dollar-based hedge funds) and the "real engineers" (Chinese policymakers).

Foreign exchange markets are, in theory, zero-sum games: the buyer's loss is the seller's gain, and vice-versa. Financial engineers love speculating on these markets, because transaction costs are very low and leveraged naked shorts are allowed, without the need to hedge an underlying asset. The exchange rate, however, is an asset price that has huge economic spillovers, because it affects real trade and flow of direct investment.