HONG KONG – The Chinese economy has caught a surprisingly severe cold this
winter – a cold so bad that almost all global markets are sneezing. During the first two
weeks of 2016, the Shanghai Composite Index fell 18%. On January 15, the index
closed at 2,901 – very close to the trough of last summer’s stock-market crash.
Foreign analysts almost uniformly predict another market crash or even a hard
landing. With oil prices dipping below $28 per barrel, the specter of a global
economic pandemic has appeared.
China’s New Year financial-market shock has been attributed to several causes,
primarily related to policy transparency and clarity. One was the reversal of China’s
attempt to install a stock-market “circuit breaker,” which, far from tempering volatility,
spurred a new wave of selloffs. The other – arguably more serious – problem was
market confusion about the direction of the renminbi exchange rate, following a
gradual but constant ten-day depreciation against the US dollar that fueled capital
outflows, until the People’s Bank of China (PBOC) intervened.
According to the PBOC, the confusion arose from a technical change in the process
of setting the renminbi exchange rate, with the common reference rate against the US
dollar replaced by a rate established on the basis of an undisclosed basket of key
international currencies. This reform may be intended to boost the renminbi’s stability;
but it is not good for markets, which prefer stability against the dollar to the
uncertainty of a managed float.
This is not the first time markets have felt blindsided by well-meaning reforms. Last
August, the PBOC announced a more market-oriented mechanism for setting the
renminbi exchange rate in the interbank market, with the daily fixing rate to be based
on the previous day’s closing price. But, because the move coincided with a one-time
devaluation of 1.9% against the US dollar, markets wrongly assumed that the central
bank would pursue a policy-induced depreciation.
Unclear policy communication was compounded by global developments. The US
Federal Reserve’s decision in December to raise the federal funds rate, together with
the uncertainty generated by collapsing oil prices, has also spurred investors to
reduce their China exposure and switch to dollars. Recognizing that exchange rates
can overshoot much more than the stock market, especially in emerging economies,
the PBOC moved to stabilize the exchange rate, intervening heavily in the offshore
renminbi markets and tightening controls on short-term cross-border capital flows.
In December, China’s government reiterated its commitment to implementing tough
market-oriented reforms, including measures to address environmental pollution,
overcapacity, excessive debt, high taxes, bureaucratic red tape, and monopoly
privileges for state-owned enterprises (SOEs). The problem is that short-term
investors are unlikely to wait around for long-term reforms to pay off – preferring short-
term hedges against unclear exchange-rate policy.
All modern economies struggle with the inconsistency between sharp and volatile
short-term price movements in financial markets and more gradual long-term
structural adjustments in the real economy. Unlike in the past, when Chinese
policymakers were able to concentrate on the real economy without worrying about
excessive financial-market instability, they now must manage short-term volatility
caused by liberalized interest and exchange rates, together with larger and faster
capital flows both within and across borders.
For China, coordinating short-term Keynesian fiscal and monetary policies aimed at
stabilizing markets with long-term changes to the industrial structure – all without
allowing growth to fall low enough to disrupt expectations – will be no easy feat. But
one thing is clear: effective communication with market participants and real-economy
players is crucial to market credibility and stability.
In relatively closed economies, explaining complex policies is less important than
delivering results. But with increasing foreign participation and interaction,
maintaining stability means anchoring market confidence with transparent, credible
policymaking and action.
Only with market-savvy central- and local-government officials and SOE managers
can China implement short-term stabilization measures or long-term structural
reforms. The problem, as China Securities Regulatory Commission Chairman Xiao
Gang recently lamented, is that such talent is not widely available in the country;
those who possess it tend to seek higher pay elsewhere, worry about the limits of the
authorities’ market-friendly approach, or even feel vulnerable to corruption
accusations.
The key to attracting market-oriented talent to China’s large bureaucracy is to make it
clear that risk-taking – and even failure – will be tolerated. Only if skilled officials feel
comfortable making real-time decisions under uncertain conditions can the state keep
pace with markets, responding effectively to new developments and thus maintaining
high levels of confidence. To support officials during this process, which will include
unpopular decision such as cutting capacity and restructuring failed enterprises,
China also needs transparent processes that ensure fairness to all stakeholders.
China is in a strong position to handle the challenges that it faces. Growth, while
slower than in the last three decades, remains relatively strong, as does China’s
foreign-asset position and its central-government and household-sector balance
sheets. Stable markets need stable policy transitions. By installing officials with
strong policy credibility and the ability to handle market volatility deftly, China can
complete its transition to a more market-oriented, innovation-driven economy – one
that also supports stronger global growth.
A version of this article appeared in Project Syndicate, 31 January 2016
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