Weeks of selling pressure in the Chinese stock market suggested it would drop like a stone once government support ceased. So Monday's surprise was not the Shanghai Composite Index's 8.5% fall, but rather the global reaction. Why did equities fall nearly everywhere, including another nearly 600-point plunge in the Dow Jones industrials?
Through previous booms and busts, China's market has never had much connection with the real economy. But that seems to be changing. At the very least the current crash coincides with a growth slowdown and capital outflows, three trends that may be mutually reinforcing.
Meanwhile, China's global economic footprint has never been larger. China still isn't as large a source of final demand as the U.S. and Europe, and its financial system is largely walled off from the rest of the world. But if China stops importing raw materials for new bridges, factories and apartment buildings, it would remove what has been one of main drivers of growth in a world economy that has few bright spots.
There is so much negative news from China at the moment that it's impossible to avoid the conclusion that we're seeing a major stress test of the Chinese growth model. So it's important to note that a systemic crisis remains unlikely.
China's economy is still growing at a respectable rate, probably slower than the official goal of 7% but perhaps around 5%. The Communist Party controls the commanding heights of the economy, and a modest national debt leaves room to recapitalize the banking system. China enjoys two other key advantages: a hoard of foreign exchange reserves to defend against a balance-of-payments crisis, and a high savings rate that has kept the banking system liquid even when it was probably insolvent from bad loans.
Those advantages have also created new vulnerabilities, however. Since capital controls kept domestic savings from seeking better returns abroad, the government was able to harness savings to keep interest rates artificially low. That created higher levels of investment, about 50% of GDP, and faster growth than the world has seen in a major economy.
This growth and a highly motivated workforce also attracted global capital. In order to keep these inflows from forcing up the value of the yuan and creating inflation, the People's Bank of China bought foreign currency with yuan, and then removed those yuan from circulation. It did so by issuing bonds or raising the level of reserves banks are required to keep, a process known as sterilization.
The result was a Goldilocks economy that for much of the 2000s grew quickly without overheating. The sterilized inflows drove the deepening of the financial system and expansion of the money supply. That underpinned loans for investment as well as speculation, especially in real estate. And the pressure on the yuan to appreciate created a virtuous cycle of more capital inflows.
This investment boom on steroids started to unravel during the 2008 crisis, after which Beijing extended it with financial stimulus and then a stock market bubble. But as confidence in rapid growth has ebbed, capital flows have reversed and begun moving out, turning a virtuous cycle into a vicious one.
China's forex reserves fell to $ 3.65 trillion at the end of last month from a peak of $ 3.99 trillion in June 2014. The outflows drain liquidity from the banking system, which puts the central bank in an awkward position. It can let interest rates rise, further slowing the economy. Or it can ease monetary policy, which would create an expectation of yuan depreciation, leading to more capital flight.
There is little danger that Beijing's massive reserves will run out. But continuous capital outflows could still do considerable damage in conjunction with a rise of loan defaults. Banks could become unable to lend, starving the economy of credit.
This is why the world is suddenly taking every piece of bad news from China seriously. The country's record growth over two decades was real, but it was not the result of brilliant technocrats in Beijing. China benefited from a capital tailwind that has now turned. China still has policy maneuvering room to avoid a recession—for example, by cutting requirements for bank reserves. But the world is figuring out that its economy is far more vulnerable than it has seemed.
No comments:
Post a Comment