LONDON: If China really is trying to drive down its currency to gain trade advantage, the world faces an extremely dangerous moment. Such desperate behaviour would send a deflationary shock through a global economy already reeling from near-recession earlier this year, and would risk a repeat of East Asia's currency crisis in 1998 on a planetary scale.
China's fixed investment reached $5 trillion last year, matching the whole of Europe and North America combined. This is the root cause of chronic overcapacity, from shipping to steel, chemicals and solar panels.
A Chinese devaluation would export yet more of this excess supply to the rest of us. It is one thing to do this when global trade is expanding: to do so in a trade slump amounts to beggar-thy-neighbour currency warfare. It is little wonder that the first whiff of this mercantilist threat has set off an August storm, ripping through global bourses. The Bloomberg commodity index has crashed to a 13-year low.
Europe and America have failed to build up adequate safety buffers against a fresh wave of deflation. Core prices are rising at a 1pc rate on both sides of the Atlantic, a full six years into a mature economic cycle. One dreads to think what would happen if we tip into a global downturn when interest rates are still zero, quantitative easing is played out, and debt levels are 30 percentage points of GDP higher than in 2008. "The world economy is sailing across the ocean without any lifeboats," said Stephen King from HSBC.
Beijing knows this, and it also knows that the US Congress would react badly to any sign of currency warfare by a country that racked up a record trade surplus of $137bn in the second quarter. Senators Schumer, Casey, Grassley, and Graham have all lined up to accuse Beijing of currency manipulation, a term that implies retaliatory sanctions under US trade law.
Any political restraint that Congress might once have felt is being eroded fast by evidence of Chinese airstrips on disputed reefs in the South China Sea, just off the Philippines.
Whether China has in fact made a conscious decision to devalue is far from clear. Bo Zhuang from Trusted Sources said there is a "tug-of-war" within the Communist Party.
All the People's Bank of China (PBOC), the central bank, has done so far is to switch from a dollar peg to a managed float, moving a step closer towards a free market system. The immediate effect was a 1.84pc fall in the yuan against the dollar on Tuesday, breathlessly described as the biggest one-day move since 1994. The PBOC said it was merely a "one-off" technical adjustment.
If so, one might also assume that the PBOC would defend the new line at 6.32 to drive home the point. What is faintly alarming is that the central bank failed to do so, letting the currency slide a further 1.6pc yesterday before stepping in.
The PBOC put out a soothing statement, insisting that "currently there is no basis for persistent depreciation" and that the economy is in any case picking up. So take your pick: conspiracy or cock-up. The proof will now be in the pudding. The PBOC has $3.65 trillion of reserves to prevent further devaluation for the time being. If it does not do so, we may legitimately suspect that Beijing has opted for currency warfare.
Personally, I doubt that this is the start of a long slippery slide. The risks are too high. Chinese companies have borrowed huge sums in US dollars on off-shore markets to circumvent lending curbs. Devaluation would risk setting off serious capital flight, far beyond the sort of outflows seen so far, with estimates varying from $400bn to $800bn over the past five quarters.
This could spin out of control if markets suspect that Beijing is itself fanning the flames.
The slowdown in China is not yet serious enough to justify such a risk. True, the trade-weighted exchange rate has soared 22pc since mid-2012, the result of being strapped to a rocketing dollar at the wrong moment. This loss of competitiveness has been painful but it was not the chief cause of the crunch in the first half of the year. The economy hit a brick wall because monetary and fiscal policy were too tight.
The authorities failed to act as falling inflation pushed one-year borrowing costs to 5pc in real terms last year, up from zero in 2011. They also failed to anticipate a "fiscal cliff" at the start of the year as official revenue from land sales collapsed and local governments were prohibited from bank borrowing. The calibrated deleveraging by premier Li Keqiang simply went too far. He has since reversed course. Nomura says monetary policy is now as loose as in the depths of the post-Lehman crisis.
It is worth remembering that Beijing is no longer targeting headline growth. It is tracking employment, a far more relevant gauge for the survival of the Communist regime. On this score, there is no crisis. The economy generated 7.2m extra jobs in the first half of 2015, well ahead of the 10m annual target.
Few dispute that China is in trouble. Credit has been stretched to the limit and beyond. The jump in debt from 120pc to 260pc of GDP in seven years is unprecedented in any major economy in modern times.
China faces the impossible contradiction of trying to achieve hi-tech economic growth with top-down political control and spreading repression. That way lies the middle income trap, the curse of all regimes that fail to reform in time. Yet this is a story for the next 15 years. The Communist Party has not yet run out of stimulus. One day China will pull the lever and nothing will happen. We are not there yet.