THE BLOG
08/12/2015 01:30 am ET Updated Aug 11, 2016

China's Sudden Currency Depreciation: High Anxiety and Lost Face

In the ongoing battle between the markets and the Chinese central government, the sudden 2 percent devaluation of the yuan represents a colossal loss of face, not to mention a further signal of the economy's underlying weakness. A shrinking auto sector -- insiders expect retail sales to decline 15 percent in 2015 -- is but one harbinger of choppy seas.

The People's Bank of China has tried, unconvincingly, to dress up the largest depreciation as an attempt to correct "distortions" and a "one-off move to fix the discrepancy between the reference rate and the market's spot rate."

Some Western commentators have embraced the move as a step toward liberalizing the yuan because, per sanctioned media releases, "the exchange rate will will be based more on the previous day's closing rate at the interbank foreign exchange market." Only time will tell whether the government has the stomach to allow the the yuan to rise and fall freely.

I'm no currency expert. But coming on the heels of a ham-handed intervention in the stock market, the abruptness of the depreciation seems to be an obvious short-term move to increase export competitiveness. More worryingly, it is also a tacit admission that China's leaders are very nervous.

Economist Paul Krugman's assertion that they "have no idea what they are doing" is too harsh. Turning a tanker as massive as the Mainland's economy is no easy feat and, given rulers' penchant for both secrecy and incremental tinkering, progress is often difficult to assess from the sidelines. Still, the whiff of panic is becoming sharper.

The legitimacy of Xi Jinping's regime rests on two planks. First, his anti-corruption campaign, despite widespread assumptions it masks score settling, has stirred hearts by reinforcing the president's man-of-the-people appeal. The drive has also whetted expectations that his consolidation of power will provide the political capital necessary to carry out sensitive reform.

Few deny the need to re-engineer China's economic model. The importance of (increasingly inefficient) capital investment and exports buttressed by (increasingly scarce) cheap labor must decline relative to the contribution of consumer spending and the service sector.

The reversion to an old economic playbook -- that is, a cheaper currency to boost the manufacturing sector -- represents a loss of national face. It is a bitter pill to swallow, one I suspect has been resisted for some time. The central government, eager to be perceived as standing tall on the world stage, is ultra-sensitive to any dilution of global stature. Mr. Xi's "China Dream" is rooted in prideful regional dominance. On both personal and national levels, the primacy of face, the fuel of forward advancement, is fundamental. It is sacrificed only as a last resort.

The depreciation smacks of fear for another reason. The Chinese cherish stability. It is a "platform" on which progress is constructed. Heretofore, the long game of economic reform has been deliberate but it has also been meticulously incremental.

But the Great Leap Forward, a crackpot economic strategy to industrialize the countryside, and the Cultural Revolution, ten years of destructive chaos, reveal another facet of China's psyche: the potential for anxiety to trigger impulsive decisions.

The tone deaf brusqueness of the currency intervention is inconsistent with the regime's cautious "lay low" approach to international engagement. It has destabilized currency markets and raised bold question marks on China's ultimate intentions. Leadership must now bend over backwards to reassure trading partners about its commitment to market-driven reform. If not, China's image as a "responsible stakeholder" in global institutions, so crucial to nation's rise, will suffer a blow.

Can China's growth model be reinvigorated? Yes. The digital revolution has broadened horizons. According to the National Business Daily, more than 10,000 enterprises are founded every day and the majority are Internet companies -- a burst of creative entrepreneurialism and democratized market opportunity ripe for the picking. And China's leadership is increasingly branché, sensitive as never before to the realities of globalism.

But to reach the next level of prosperity, Beijing's mandarins will need to resist a basic instinct to control, well, everything. Yes, foreigners do not appreciate the exquisite delicacy of the central government's balancing act. But, still, the genie of China's economic dynamism is out of the bottle. And the PRC's upwardly ambitious middle class has achieved critical mass. The country's institutions need to evolve with the times, lest the Chinese people lose faith in a paternalistic government's ability to slowly but surely implement an economic agenda that delivers broad-based opportunity. Should that happen, Xi JinPing's Mandate of Heaven will evaporate and the world will be a much more uncertain place.