The Bush Leaguers of Beijing

What better way for China to cement its role in the global economy than to be the trigger of a global financial crisis? It was the United States in 2008 and Europe in 2011 and 2012; now it is China that is sending shockwaves through financial markets. Just as Beijing insists, the global economy is now multipolar — no longer an American-dominated block with the dollar at its core. And like it or not, China has become one of these poles — perhaps before it was quite ready.

To appreciate how much the world and the role China plays within it have changed, think of various recent financial crises. In 1997, at the time of the Asian financial crisis that devastated a number of economies in the region, from Thailand to South Korea, China remained at the margins of the turmoil. Back then, despite its fast growing economy and strong exports, China was a financially isolated economy with an non-convertible currency and was still at the edge of the international trade system; at that time, the Chinese leadership was busy implementing the reforms necessary to join the World Trade Organization, which finally happened in 2001.

In 2008, when the collapse of Lehman Brothers almost brought to a halt the American banking and financial system — which had significant impact on the rest of the world — China, once again, was to a large degree financially isolated, with a non-convertible currency. Thus, like other developing countries, it managed to keep itself largely immune from the financial contagion, but it experienced second-round effects on the real economy — indeed, the crisis in the United States and then in Europe resulted in a drop in Chinese exports.

This time is different. China is no longer at the margins as in 1997, nor is it an innocent bystander as in 2008. It is at the core of the current episode of financial instability. With approximately a 16 percent share of the world’s output, China is a key component of the global economy. And, with many advanced countries in the grips of the new normal of low growth and deflationary pressure, a slowdown in Chinese economic growth spells trouble throughout China’s global supply chain.

The demand for commodities by Chinese companies has dropped — imports of many industrial commodities are down for the first half of 2015, including a decline of 1 percent for iron ore, and 11 percent for copper. Recent figures on economic activity — including year-on-year declines of 0.1 percent on value-added industrial production growth, 0.2 percent in retail sales growth and 2.1 percent in fixed asset investment growth — have also dented investors’ confidence, both in China and abroad. And finally, the deep drops in Chinese stock markets and the badly timed adjustment in the value of the renminbi — allegedly to make the Chinese currency’s value more market-based — have thrown global investors off the rails.

It didn’t take a very big straw to break this camel’s back. Markets have been nervous about China for some time. After all, this is a country with murky governance and a level of indebtedness of more than 250 percent of gross domestic product, unique among middle-income countries. Limited options for savers beyond poorly remunerated bank deposits have fed bubbles — such as in the real estate sector and, more recently, in the so-called “shadow banking” sector, whereby savers are lured into high-risk wealth products by higher interest rates than those provided by bank deposits. In addition, the huge increase in the market value of Chinese companies between May 2013 and May 2015 — more than 150 percent — appeared in suspiciously stark contrast to the smaller growth in many advanced economies. As valuations looked increasingly unsustainable, market participants were more and more sensitive to bad news that could trigger a significant adjustment.

Even the slowdown in the Chinese economy, which has been in the cards for some time as part of the plan to reform China’s model for growth, has become an area of concern. The idea is to shift the focus to domestic demand — as opposed to exports — and to promote a more productive and balanced use of resources, including financial capital. The reform of the banking and financial sector to build a market economy with “Chinese characteristics” is part of this overall plan, and includes making both the interest rate and the exchange rate more market-oriented, instead of being determined by the authorities on the basis of their policy goals.

Implementing this plan is politically complex, and so far it has been messy, often with contradictory policy measures. For instance, the decision early this month to allow more flexibility in trading of the renminbi was so poorly timed that the People’s Bank of China had to intervene repeatedly to support the currency — exactly the opposite of the expected outcome. Possible explanations include a lack of experience in communicating with markets — the bank’s governor didn’t even show up for its press conference on the subject — a lack of credibility, or both. The reality is that China has become an integral part of global markets, but isn’t yet ready to play the market game. As its policymakers struggle to find their way, stock markets in the United States and Europe have felt the effects, and currencies in emerging markets economies — from Malaysia to Russia — have been abruptly punished by the renminbi’s depreciation.

Even more significantly, the pressure is now on the Federal Reserve to keep interest rates on hold until the Chinese authorities get the situation under control, or at least until markets believe that they have it under control.

Of course, China has some of the tools to clean up its own mess. With $3.69 trillion in foreign exchange reserves, down from a peak of $3.99 trillion in 2014, Beijing still has considerable scope for maneuvering — either by supporting the renminbi or by buying into securities markets. But this is exactly the problem. Market intervention feeds expectations for more market intervention, down into a self-fulfilling spiral that takes China further away from liquid capital and currency markets capable of solving some of their own problems. Not long ago, the discussion about China centered on its efforts to make the renminbi an international asset and a reserve currency. But how can it be, when the authorities are expected to and regularly intervene in the stock market and manage the exchange rate?

China has let the genie out of the bottle and does not know how to push it back in again. So should the authorities just let markets adjust? Such an adjustment might wipe out the savings of many households, as a large proportion of China’s stock market is in the hands of retail savers. Or should the authorities intervene and, for example, put limits on share sales? This would preserve financial stability and the nation’s wealth at the costs of international credibility.

There is no easy option. One thing, however, is for sure: China has grown into a key player in the global economy before completing the necessary rebalancing of its economy and financial reforms, and following this new road will be very bumpy for China and for the world.

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