Author: Peter Drysdale, East Asia Forum
The economic tremors that accompanied the New Year falls in the Chinese stock market have spooked markets and policymakers around the world. Get used to it.
China’s now big enough to matter in markets everywhere. In terms of its share of global output, global growth of GDP and commodities markets, China matters more than almost any country, including — in these latter dimensions — the United States. Few wanted to miss out on the economic benefits from being hitched to the United States, despite downsides like the fallout from its financial implosion in the global financial crisis. Revealed choice shows that few want to miss out on the economic benefits from being hitched to China now that it’s open for business and up there, despite the risks of financial and other shocks that will inevitably occur in that big economy.
That said, the jumping at shadows that has characterised the recent response of the international markets and some analysts to developments in the Chinese economy may be an understandable by-product of getting to know what matters and what to expect in the course of the huge economic transformation that is taking place in China. But it is froth and bubble on top of what is really going on in the Chinese economy, although it is also one of the major challenges in implementing the big and soundly-directed reform strategies — on financial markets, the capital account and the currency regime — to which the Chinese leadership has committed.
Consumption, not manufacturing output, is now driving the Chinese economy. Last year, consumption accounted for 60 per cent of Chinese GDP growth, far more than the old drivers of investment and net export growth. In recent months retail sales are up by almost 11 per cent, online sales by over 34 per cent and the services sector is continuing to expand month on month.
In fact the sell-off in the Chinese stock market had little to do with fundamentals in the Chinese economy or the movement in the Chinese exchange rate. Of course, trying to understand exactly what drives day-to-day gyrations in the market is always a challenge. But it is pretty clear that the sell-offs in Shanghai earlier this month had a great deal to do with the expiration of the six month ban, imposed by China’s securities regulator, on selling by major shareholders. And another factor was the way in which the operation of a new ‘circuit-breaker’ spooked flighty Chinese investors. Regulators needed to review the way in which these measures affected Chinese markets — and they have.
China’s stock market is still very underdeveloped and it plays a very small role in the economy. It’s about a third of GDP, by one measure, compared with more than 100 per cent in developed economies. Less than 15 per cent of household financial assets are invested in the stock market. That’s why rising share prices did little to boost consumption on the way up and why falling prices do little to hurt it. The players in the market are small. Institutional investment is under-represented. Corporations do not yet rely on equity financing for investment. The connection between the stock market and China’s economic performance is weak. And what is happening in Chinese stock markets is a premature basis for calling the collapse of the Chinese economy.
Some reckon that the stock market collapse was brought on by the depreciation that the Peoples’ Bank of China has allowed in the Chinese currency over the past year. It shed 4 per cent of its value against the US dollar last year and more than 1 per cent so far this year. Though the depreciation of the yuan may have contributed to nervousness in international markets — as did tumbling oil prices — the new flexible exchange rate regime that China has put in place over the past year is imperative to the realignment of the Chinese and global capital markets, and the success of the Chinese reform program. The yuan is overvalued against the dollar and had to exit the effective dollar peg. This development is a significant signal to the international economic community that China has formally — and irrevocably — taken a major step along the road to market-based currency valuation.
In this week’s lead, Sourabh Gupta argues that: ‘The elevation [of the renminbi as an Special Drawing Rights basket currency] is recognition of the progress made by Beijing over the past half-decade in liberalising and deepening its monetary and financial systems. It is also a vindication of the renminbi (RMB) internationalisation strategy championed by the People’s Bank of China under Governor Zhou Xiaochuan’.
As Gupta points out, the RMB will nonetheless only gradually assume a position alongside the dollar as a major reserve currency in the international system. This will occur ‘as renminbi-based claims increasingly circulate overseas, as an active secondary market for RMB-denominated securities — open to residents and non-residents alike — acquires qualitatively greater depth, and as the People’s Bank establishes its credentials as a market-maker of last resort for such securities’.
This is a risky transition. Beijing will have to guard carefully against exchange rate overvaluation and the financial excesses that typically accompany rounds of financial deregulation. If China is to play banker to the world, it will ultimately have to be prepared to borrow short, lend long and bolster its ‘lender of last resort’ function with a fiscal backstop that is globally credible.
In 2015, the IMF agreed to include the RMB in the Special Drawing Rights basket, securing Chinese compliance in a steady and stable transition in the Chinese currency regime, avoiding fears of a currency war.
The nervousness in international markets about the drop in Chinese stock prices, and the move to a new foreign exchange rate regime with more flexibility against a currency basket over the past year, are harbingers of the ongoing difficulties in managing this critical policy change. The process needs to be incremental, and carefully staged and timed to avoid potentially substantial financial and foreign exchange risks. It is by no means just a technical economic challenge.
Integrating China into international capital markets will require China to have a much more open and transparent set of institutional arrangements to build international confidence in dealing in Chinese financial assets — and that will also push at the envelope of political reform.
Peter Drysdale is the editor of the East Asia Forum.