Under pressure.

Photographer: Tomohiro Ohsumi/Bloomberg

Outside Forces Drive China's Big Flip-Flop

Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE and chairman of the President’s Global Development Council, and he was chief executive and co-chief investment officer of Pimco. His books include “The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse.”
Read More.
a | A

For all its political intrigue over the years, China has had a relatively clear economic strategy, at least until recently. In the last few weeks, however, its approach to managing its exchange rate has puzzled those who closely follow it. The move by China’s central bank on Friday to cut interest rates adds to the surprise, as does talk of further monetary stimulus.

At the risk of some over-simplification, China’s economic strategy has been steadfast in making a gradual transition from a growth model heavily reliant on exports and public investment to one driven much more by domestic consumption and private investment. This is part of China's broader “middle income transition,” as the development stage is known, that faces challenges in today’s weakening global economy, as well as from the historically entrenched power of inefficient state-owned enterprises and "bubblish" pockets of financial excess.

Most important, China’s leaders are determined to make this transition without a significant economic slowdown:  Maintaining an average annual growth rate in the 7 percent range is seen as critical to social and political stability.

China’s strategic approach has had to be reconciled with competing shorter-term considerations, including sluggish U.S. growth, Europe’s debt crisis and large waves of global capital flows. At times, Chinese officials have had no choice but to go back and try to get more growth out of the old approach, including using fiscal and monetary stimulus that operates mainly through the state-owned enterprises and that risks aggravating financial excesses in shadow banking, real estate and other sectors.  The prime example was in 2009 when China embarked on a huge fiscal and monetary expansion to counter the effects of the global financial crisis.

These episodes aside, China has tried to avoid complicating its economic transition with short-term detours. As such, it had been careful to keep its managed currency from appreciating too rapidly. In the last few months, however, it has happily allowed the yuan to strengthen markedly alongside the appreciating dollar to which it is linked through a semi-pegged exchange-rate system.

The result has been the currency’s sharp rise against the euro and the yen, and even more against some emerging-market currencies such as the Korean won. This creates a headwind to growth, given the detrimental impact on China’s exports. The policy is surprising given the emphasis that Chinese officials have put on steady economic expansion as a means of absorbing migration from the countryside and maintaining social and political harmony.

Until last Friday, an appreciation in the currency could possibly be justified by two considerations: the downward pressure it places on domestic inflation and the incentive it gives Chinese companies to compete more efficiently. But Friday’s surprise cut in interest rates has made such an interpretation less straightforward. If anything, the lowered interest rate undercuts it, since the move runs counter to the appreciation of the currency and provides cheap financing to inefficient state-owned enterprises.

China’s apparent flip-flop on policy illustrates a bigger reality facing emerging economies. Even well-managed ones such as China have difficulty in navigating a fluid global economy that has been distorted by the West’s incomplete response to its problems and its prolonged reliance on experimental central bank policies, including negative real interest rates and other measures to artificially boost asset prices.

Being at the receiving end of this, emerging economies often find themselves having to respond to conflicting external influences over time. And in their efforts to be responsive, they often end up taking inconsistent approaches themselves.

Facing this unfortunate reality, at least China has the advantage of being domestically anchored by a clear vision of its approach and how to carry it out. Thus, its deviations tend to be limited in both duration and damage.

Unfortunately, the same can't be said of other emerging economies that lack such an internal anchor. You need only look at the challenges facing Brazil, for example, to see how unfavorable external influences can accentuate domestic weaknesses and, in the process, blow sound economic management off course.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Mohamed A. El-Erian at melerian@bloomberg.net

To contact the editor on this story:
Katy Roberts at kroberts29@bloomberg.net