Mak­ing sense of China's cur­rency move

The Pak Banker - - OPINION - Mo­hamed A. El-Erian

China on Tues­day took a step it had re­sisted dur­ing the global fi­nan­cial cri­sis: It openly de­val­ued its cur­rency to boost its econ­omy. With this move, China ex­plic­itly joins other na­tions try­ing to cap­ture eco­nomic ac­tiv­ity out­side their borders, and it is do­ing so as the global econ­omy is strug­gling to gen­er­ate suf­fi­cient growth. The de­ci­sion there­fore pro­vides many sig­nals about what ails China and the global econ­omy, and has im­pli­ca­tions for fi­nan­cial mar­kets.

The Chi­nese gov­ern­ment has been pressed for years to adopt a more flex­i­ble, mar­ket-based for­eign-ex­change sys­tem, no­tably by the U.S. The In­ter­na­tional Mon­e­tary Fund made a sim­i­lar point dur­ing re­cent de­lib­er­a­tions over the yuan's in­ter­na­tional sta­tus.

But by heed­ing this ad­vice now, China has done more than de­value its cur­rency by al­most 2 per­cent, the largest sin­gle-day move in two decades. By choos­ing this par­tic­u­lar mo­ment to al­ter its cur­rency sys­tem, it is also at­tempt­ing to re­spond -- via for­eign-ex­change pol­icy -- to one of the big­gest chal­lenges fac­ing the global econ­omy, that of gen­er­at­ing growth.

For a time af­ter the global fi­nan­cial cri­sis, the prob­lem of cre­at­ing and sus­tain­ing high­qual­ity growth was con­tained pri­mar­ily to ad­vanced economies. But the more these coun­tries failed to deal with this ques­tion, the greater the ad­verse spillovers for emerg­ing economies. Now the lat­ter also are strug­gling to gen­er­ate suf­fi­cient growth.

The longer coun­tries fail


de­liver do­mes­ti­cally driven growth, the more they will be tempted to "steal" it from oth­ers. A time-tested way of try­ing to do so is to de­value a na­tional cur­rency in an at­tempt to make ex­ports more com­pet­i­tive and im­ports more ex­pen­sive -- thus di­vert­ing both in­ter­nal and ex­ter­nal de­mand to do­mes­tic pro­duc­tion, at the ex­pense of for­eign sup­pli­ers.

By tak­ing a step in this di­rec­tion, China is now fol­low­ing a path that many other ad­vanced and emerg­ing economies have been at­tempt­ing to take for some time (in­clud­ing the euro zone via the Euro­pean Cen­tral Bank's quan­ti­ta­tive eas­ing pro­gram).

In­deed, China's de­ci­sion leaves the U.S. as the only sys­tem­i­cally im­por­tant coun­try will­ing to ac­cept the strength­en­ing of its cur­rency. But what may work for in­di­vid­ual coun­tries can­not work for the sys­tem as a whole; and that has im­pli­ca­tions for fi­nan­cial mar­kets.

The tim­ing of China's pol­icy de­ci­sion sig­nals that one of the largest and most sys­tem­i­cally im­por­tant economies is no longer in a po­si­tion to play its long­stand­ing role as a lo­co­mo­tive of global growth. The tail­wind China has pro­vided other coun­tries now risks be­com­ing a head­wind.

Ro­bust global eco­nomic ac­tiv­ity is cen­tral to sus­tain­ing cor­po­rate rev­enue and profit; and it lim­its the abil­ity of bad pol­i­tics to con­tam­i­nate good eco­nom­ics. China's de­ci­sion must also be a con­sid­er­a­tion in other im­por­tant pol­icy changes that in­flu­ence mar­kets, in­clud­ing the Fed­eral Re­serve's in­tense de­lib­er­a­tions on when to start its in­ter­est rate hik­ing cy­cle.

The im­me­di­ate con­se­quence of the yuan's move is the ap­pre­ci­a­tion of the dol­lar's tradeweighted ex­change rate, which will be am­pli­fied as other cur­ren­cies re­spond.

And ex­ces­sive dol­lar ap­pre­ci­a­tion has been one of the con­cerns high­lighted by the Fed­eral Re­serve as a pos­si­ble coun­ter­point to the grow­ing list of do­mes­tic rea­sons de­mands to in­crease U.S. in­ter­est rates as early as Septem­ber.

There are other mar­ket im­pli­ca­tions, too. China's pol­icy de­ci­sion has great­est di­rect im­pact on a seg­ment -- for­eign ex­change -that has a ten­dency to over­shoot (that is, to move in volatile fash­ion to lev­els that ex­ceed those war­ranted by fun­da­men­tals). This is true for emerg­ing mar­ket cur­ren­cies, es­pe­cially those that lack a broad-enough base of ded­i­cated in­vestors.

In time, China's cur­rency move will be viewed as an im­por­tant step in the coun­try's mul­ti­year jour­ney to­ward a more ef­fi­cient and re­spon­sive mar­ket-de­ter­mined sys­tem. In the short term, how­ever, it will am­plify the chal­lenges to global growth, and add volatil­ity to mar­kets that have lost some of their fun­da­men­tal an­chor­ing.

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