China's prices are falling. Its currency could be next

Deflation is officially stalking the Chinese economy, and the People’s Bank of China faces an acute monetary trilemma. With July consumer prices slipping into negative territory at minus 0.3 per cent year-on-year, domestic price pressures have collapsed under the weight of real estate distress and fragile consumer sentiment. Standard economic textbooks prescribe aggressive monetary loosening, but Beijing is constrained by its currency.

The Defense of the Redback

Aggressive policy rate cuts to combat deflation would violently widen the interest rate differential between the yuan and the dollar, triggering aggressive capital flight and intense downward pressure on the currency. To prevent a destabilizing rout, the PBoC has deployed aggressive strong-side daily fixings and ordered state banks to absorb dollar liquidity. Defending the yuan limits the central bank’s ability to reflate the domestic economy.

Beijing is trapped in a classic balance-of-payments bind: it cannot launch the monetary bazooka required to defeat domestic deflation without triggering a dangerous run on the yuan.