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 percent. On Jan. 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’s 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 sell-offs. The other — arguably more serious — problem was market confusion about the direction of the renminbi exchange rate, following a gradual but constant 10-day depreciation against the 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 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 blind-sided 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 percent against the dollar, markets wrongly assumed that the central bank would pursue a policy-induced depreciation.
Unclear policy communication was compounded by global developments. The U.S. 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.
Andrew Sheng is a distinguished fellow of the Asia Global Institute at the University of Hong Kong and a member of the UNEP Advisory Council on Sustainable Finance. Xiao Geng, director of the IFF Institute, is a professor at the University of Hong Kong and a fellow at its Asia Global Institute. © Project Syndicate, 2016
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