Right now the consensus is that there is only one way for the renminbi to go: up. But consider this: China’s rising inflation rate and domestic asset price bubbles in real estate and equities are the result of its one-eyed exchange rate policy. The renminbi is managed as a fixed peg in all but name. Despite a revaluation of 7%-8% against the U.S. dollar in the last year, it has weakened against the euro and the yen. That means in effective trade-weighted terms it hasn’t risen at all, despite all the rhetoric about the authorities allowing a faster rate of appreciation.

In the circumstances of China’s red-hot economy and emerging price inflation, that’s a result that China needed like a hole in the head. It has produced a massive liquidity bubble, fuelled by both trade surplus and capital inflows (betting on faster yuan appreciation). In a nutshell, the fixed exchange rate was a rigged price signal that reinforced the economic distortion of over-concentration on the export sector. This was made worse by the underpricing of key input factors like oil, where the authorities kept oil prices in the mid-$50 per barrel range, making exports more attractive than they should be if energy were priced at world market prices.
   

All this combined to postpone the goal of shifting China’s economy to a more domestically oriented model, with greater emphasis on the consumer and services. It also increased vulnerability to any downturn in global demand. Now the chickens are about to come home to roost. There can be no doubt in anyone’s mind that global liquidity is contracting, as the global credit machine is truly broken. And credit shrinkage will cause recessions in all three of China’s major trading partners (Europe, the U.S. and Japan). The upshot of both developments will be less excess liquidity flowing into China in the form of foreign direct investment and speculative capital as well as falling exports and trade surplus.

When that happens, the Chinese authorities will face a dilemma. The trade surplus and accumulated capital investment in the export sector is, at a rough guess, equal to about 15%-20% of GDP. That is a measure of the “spare” capacity China has should export growth falter. When demand falls for its exports, so will profits in a large segment of the economy.To keep the export sector liquid and solvent, there are only two options: lend it buckets of money (not a policy choice any more now that the state banks are “privatized” and in business to make a buck) or make exporters’ products super-cheap so that they sell abroad despite recession in client countries.

As cost inflation in China is high and likely to remain so for quite a while, the only way to make the export products cheap is to devalue the renminbi against all major currencies. In other words, the Chinese would join the race to debase its currency like so many other central banks faced with credit woes.

My bet is that when central bankers act in chorus to achieve competitive devaluations at the expense of their trading partners, protectionism is the “normal” but political response. Under a U.S. Democratic administration, whose economic acumen will likely make the outgoing Bush executive look brilliant, protectionism is almost a certainty. And in the past, protectionism has been responsible for more and deeper economic crises than even credit bubbles.

Mr. Roche, president of Independent Strategy, a global investment consultancy based in London, is the author of “New Monetarism” (Independent Strategy, 2007).