LONDON – The Year of the Monkey is well into its third month – and the rest of the world must hope that China’s authorities will soon start to live up to the monkey’s supposed cleverness. So far, the evidence is unconvincing. The Shanghai Composite Index dropped by 18% in the first two weeks of 2016, and has endured lesser falls since then; the renminbi has been on a downward trend since late 2014; and economic growth continues to slide. In short, it looks to many people as if China has lost the plot.
ouster of Xiao Gang, the chairman of the China Securities Regulatory Commission, amplified the uncertainty. Meanwhile, the Chinese leadership faces the daunting task of rebalancing the country’s model of growth from excessive reliance on investment and exports to one more focused on household consumption and domestic services.
The critics – including commentators for Project Syndicate – have a point. The Chinese authorities’ brief experiment with a “circuit breaker” to suspend equities trading if the Shanghai index fell by 7% simply generated more panic in January, and theAndrew Sheng and Xiao Geng of Hong Kong’s Asia Global Institute, for example, believe that China’s recent financial-market turmoil is “primarily related to policy transparency and clarity.”
But China’s problems run even deeper. Much of the criticism of recent Chinese policymaking has focused on miscommunication with market actors: The key to establishing “credibility,” according to this view, is greater certainty about the authorities’ intentions.Michael Spence and the Hoover Institution’s Fred Hu, for example, believe that “China’s trajectory has become almost impossible to anticipate, owing to the confusing – if not conflicting – signals being sent by policymakers.” At the same time, “the principal unaddressed problem affecting China’s financial system is the pervasiveness of state control and ownership, and the implicit guarantees that pervade asset markets.”
Some Project Syndicate commentators, however, question whether any policy framework aimed at stemming China’s slowdown can be credible in the absence of more far-reaching governance reforms. In fact, there is merit to both arguments. Nobel laureateSupply-Side Story?
Mohamed A. El-Erian, Chairman of President Obama’s Global Development Council, points out, it is even greater for a country as large and complex as China. And it comes at a time when weak growth in virtually all of the world’s major economies is suppressing export demand before domestic consumption and services have developed sufficiently to sustain growth.
The economic rebalancing that China is now pursuing would be a major challenge for any country. AsStephen S. Roach, a former chairman of Morgan Stanley Asia, remains optimistic: “While turmoil in Chinese equity and currency markets should not be taken lightly, the country continues to make encouraging headway on structural adjustments in its real economy.” Likewise, Shang-Jin Wei of the Asian Development Bank, is convinced that China’s economic growth will continue to be the envy of others. The International Monetary Fund, for example, forecasts annual GDP growth of at least 6% over the next four years. And the expectation is that structural reforms – or “supply-side reforms” as they are called in China – will eventually lead to more balanced growth.
ButJoseph E. Stiglitz is skeptical. “In the absence of sufficient demand,” he argues, “improving supply-side efficiency simply leads to more underutilization of resources.” And the Chinese authorities’ apparent belief that they can somehow guide price movements in financial markets betrays a fundamental misunderstanding of how such markets function. “‘Markets with Chinese characteristics’ are as volatile and hard to control as markets with American characteristics,” Stiglitz rightly argues. “Markets invariably take on a life of their own; they cannot be easily ordered around.”
But will they? Nobel laureateRob Johnson, President of the Institute for New Economic Thinking, is similarly critical of supply-side reforms, which he calls “a profoundly dangerous prescription.” Like Stiglitz, he believes that the key to a soft economic landing is to boost spending. In particular, the authorities should focus on “reinvigorating aggregate demand by targeting fiscal policy to support the emerging economic sectors that will underpin the new growth model.”
What Global Threat?
Domestic shocks in China – now the world’s biggest economy in terms of purchasing power parity – have profound implications for the rest of the world. The impact is direct when it comes to trade, as China’s slowing appetite for energy and commodities reduces its imports from developing countries. When it comes to finance, however, China’s impact may be more indirect – essentially a case of inadvertently amplifying global financial instability. El-Erian, for example, draws an interesting parallel between China’s government-led expansion of equity ownership and the United States’ effort to broaden home ownership in the years before the 2008 financial crisis.
I’m not convinced. America’s 2008 crisis became global because in a world where banking knows no frontiers, the contagion was instantaneous. By contrast, given China’s capital controls, the external impact of a domestic financial crisis would be mainly on confidence and growth.
The issue that draws the most attention is the value of the renminbi. Is China indulging in competitive devaluation and hurting countries with limited international reserves (much of them held in dollars)? Frankly, it’s hard to tell, because the People’s Bank of China (PBOC) followed last August’s devaluation with frantic interventions to support the currency. To me, we are seeing the results of the monetary authorities’ inexperience, not a deliberate neo-mercantilist policy.
Barry Eichengreen, an economics professor at Berkeley, suggests that the lack of policy credibility has itself become the major driver of financial-market volatility. Many Chinese economists, including Zhang Jun of Fudan University in Shanghai, agree. He believes that “China could have communicated its new exchange-rate policy more clearly,” and that the authorities now “recognize this imperative and are working to meet it.”
But inexperience can be costly. Like Johnson,For Eichengreen, however, the problem is not just that officials’ poor communication of their intentions is “encouraging the belief that they don’t know what they’re doing.” The issue is more fundamental: “The fact is that China’s government no longer has any good options” when it comes to managing the exchange rate.
Kenneth Rogoff spells out the paradox: A country with a $600 billion trade surplus in 2015 is now worried about currency weakness. But China is not like any other country. Of course, growth is slowing and investment opportunities may look better elsewhere. But is this enough to overcome domestic investors’ home bias and trigger large capital outflows (an estimated $650 billion in 2015, according to the Institute of International Finance)?
Harvard’sYu Yongding, a former member of the PBOC’s monetary policy committee, notes, capital controls have always been porous. As Rogoff explains, “a not-so-legal approach is to issue false or inflated trade invoices – essentially a form of money laundering. For example, a Chinese exporter might report a lower sale price to an American importer than it actually receives, with the difference secretly deposited in dollars into a US bank account (which might in turn be used to purchase a Picasso).”
Clearly, the PBOC’s system of “managed convertibility,” whereby financial opening is achieved through quotas and licenses, is failing to contain the impact of excessive outflows (or inflows) on the exchange rate. AsWhat Are China’s Options?
Yu suggests three options for the PBOC: stop market intervention and let the renminbi float; link it to a basket of currencies; or peg it tightly to the US dollar. Clearly the second and third options would both tackle the current volatility – but neither addresses the fundamental issue of market intervention and the depletion of reserves implied by sustained interventions. The first solution would seem ideal to many economists, but I agree with Rogoff that it might be too late and simply trigger more outflows – quite apart from raising the accusation of a “beggar-thy-neighbor” monetary policy.
Rogoff and I are hardly alone. Eichengreen invokes the Irish joke: “If I were you, I wouldn’t start from here.” As he points out: “No question, the country would be better off with a more flexible exchange rate that eliminated one-way bets for speculators and acted as an economic shock absorber.” The trouble is that “the moment when China could smoothly navigate this transition has now passed.” As Johnson puts it, “The persistent downward pressure on the renminbi reflects a growing fear that Chinese policymakers have no coherent solution to the dilemmas they face.”
Koichi Hamada, economic adviser to Japanese Prime Minister Shinzo Abe, emphasizes, what they can’t do is stay where they are. “What Chinese policymakers don’t seem to recognize,” he says of the monetary authorities, “is that such interventions carry serious long-term costs. Few want to invest in a market where the government can change the rules at any moment.”
China’s authorities must choose between continuing to try to manage the economy and pushing faster toward a more market-oriented system. AsSheng and Xiao eloquently argue that explaining complex policies used to be less important than delivering results, so officials were able to concentrate only on the real economy. Now, however, they have to know – or learn very fast – how to manage short-term volatility and sustain market confidence with transparent, consistent, and credible action.
True enough, but both options risk further undermining market confidence and exacerbating volatility. Moreover, the authorities lack market experience.A Real Economic Mess
Adair Turner, former chairman of Britain’s Financial Services Authority. He emphasizes the difficulties that come with managing the real economy during the transition: “There is a limit to how fast any economy can shift real resources – and especially labor – among sectors. Redeploying construction workers, for example, to service-sector jobs will be a slow, difficult process.”
A key concern is that the pace of change in the real economy has lagged significantly behind that in the financial sector since 2013, when President Xi Jinping unveiled an ambitious economic-reform agenda. This should not be surprising, saysBut Roach is more cautious on this point. Strong links between state-owned enterprises and the biggest banks, he argues, remain an obstacle to transparency and proper risk assessment. And the recent financial-sector setbacks do not bode well for building an equity-funding alternative to bank credit.
Keyu Jin of the London School of Economics offers an even blunter assessment: “China’s problem is not that it is ‘in transition,’ but that the state sector is choking the private sector. Cheap land, cheap capital, and preferential treatment for state-owned enterprises weaken the competitiveness of private firms, which face high borrowing costs and often must rely on family and friends for financing.” Given perverse incentives, “many private firms have turned away from their core business to speculate in the equities and property markets.”
Likewise, Johnson argues that China’s current problems reflect not merely a bias in favor of supply-side reforms in the midst of a demand shortfall. “An equally large obstacle to China’s economic transition – the problem that almost dare not speak its name – is the widespread worship of [its] hybrid market economy,” in which “today’s muddled market incentives impede transformation by favoring state-owned enterprises.”
From Crisis to Clarity?
Justin Yifu Lin, formerly chief economist at the World Bank, remains optimistic about China’s prospects. He argues that within China, confidence in the economy’s long-term trajectory remains undiminished – not least because “less than four decades after Deng Xiaoping initiated the strategy of ‘reform and opening up,’ China has achieved upper middle-income status.” That jibes with my own sense that China’s leaders will continue to pursue a gradual approach to financial reforms and a muddle-through policy of promoting markets with “Chinese characteristics.”
But China is now at a juncture where many of its people feel tired of top-down reforms and worry about the state of society. As a good friend – and a prominent economist – said to me: “We are now eating the toxic fruit of fast growth and disparity.”
One consequence – perhaps not surprising, given Chinese leaders’ fear of political instability – has been rising authoritarianism and reassertion of state control as economic growth has slowed. In particular, Xi’s anti-corruption crackdown on top business and Communist Party leaders has been a double-edged sword: necessary to improve governance and a weapon for removing actual and potential rivals.
Minxin Pei, a professor of government at Claremont McKenna College, argues that the crackdown has made most people feel less secure. “With even routine approval of projects and requests potentially arousing suspicion,” he reports, “the Chinese bureaucracy is now paralyzed by fear.” That outcome, as Pei notes, could boost risk aversion, thereby impeding urgently needed reforms, including efforts to regain market confidence through greater transparency, or at least greater clarity in explaining policy changes.
Indeed,renminbi’s inclusion in the IMF’s currency basket for its reserve asset, Special Drawings Rights. But even the optimists have no illusions about the difficulty of the challenges China’s leadership confronts. Let us hope that Jin is right: “Good times may breed crises in the West; in China, it is crises that bring better times.”