China at the economic crossroads
SEVEN YEARS AFTER the failure of Lehman Brothers triggered a panic on Wall Street and sent the world economy into a tailspin, a free fall of the Chinese stock market has set off a new alarm. China’s stock market travails are also pulling down US and European stocks. Equity markets worldwide shed more than $2 trillion in value last week.
The problem with financial markets is that they dramatically amplify the more modest shifts of the real economy. In 2008, the US housing market was cooling after years of a housing bubble. The normal result would have been a growth slowdown, perhaps a mild recession. Yet the failure of Lehman Brothers in September 2008 led to a financial cardiac arrest. Lending between banks suddenly stopped; working capital for businesses dried up; and the world economy went into a tailspin.
Economists use the term “sudden reversals” for such sudden shifts in capital flows. One day, capital is flooding into markets and deals. The next day, the same investors are rushing for the exits. Think of a sudden stampede out of a stadium. A small event — a fight, a noise, even a rumor — can trigger a catastrophic self-fulfilling panic.
Part of the problem, long noted by George Soros and other savvy investors, is that most money managers don’t have deeply held or particularly well-informed views of market fundamentals. They go with the flow, collecting hefty trading fees and repeating clichés about market trends until they abruptly adopt new clichés. One day China is the invincible new economic power; the next it can do nothing right.
In a financial world that is so high strung, panic indeed becomes individually rational, though collectively costly. If everybody else is stampeding, the only thing to do is to run for your life as well. After Lehman’s failure, no individual bank could continue lending into the panic, even if convinced that the panic was unjustified. Only the central banks — the US Fed, the European Central Bank, the People’s Bank of China, and others — could lend into the gale. Only they could end the panic.
Fast-forward seven years to China. In fundamental terms, China is still a fast-growing developing country with many more years of rapid growth ahead. China is still catching up with the United States and Europe, albeit with a host of complicated problems — massive pollution, climate change, huge rural-to-urban migration, rising inequalities, corruption, and pockets of unrest — that create headwinds. China’s years of double-digit economic growth between 1978 and 2008 are over, but mainly because of economic success. The China of 2016 is now too rich, too developed, and too complex to grow at 10 percent per year; 6-7 percent per annum is probably still possible for some years ahead.
After the 2008 Wall Street-led crash, the Chinese economy still looked good, especially in comparison with the United States and Europe. Money poured into China. The Renminbi, China’s currency, soared, strengthening roughly 20 percent against the dollar between the end of 2006 and end of 2015, while the dollar simultaneously strengthened by around 22 percent against the euro. Against a broad basket of currencies, China’s “real” exchange rate, adjusting the exchange rate for relative price levels in China and elsewhere, strengthened by a whopping 50 percent or so, leaving China’s exports far more costly to produce and to sell abroad relative to the exports of other economies.
The Shanghai stock market also soared from the start of 2014, rising two-and-a-half times to its peak in June 2015. Yet the surge of the currency and the stock market was occurring against the backdrop of slowing growth and a maturing economy. The markets were euphoric, while the economic data and the policy makers were signaling growing caution.
In normal world, financial euphoria would also have turned into a flashing yellow light. Instead, the global financial “wrecking-ball,” in Soros’s phrase, has swung from euphoria to gloom. Suddenly, China’s growth is supposedly at an end; its policy makers can do no right; its positives are false and its negative numbers are under-stated (or so goes the new heated rhetoric).
Disaster is on the horizon. The Shanghai market composite has shed around 40 percent from the June, 2015 peak and around 12 percent since Christmas, including a couple of days last week of dramatic declines cut short by clumsy “circuit breakers” triggering market closures.
So far we have a mere financial market correction. How best can we avoid something far worse spreading to the real economy?
The answer is to keep the eyes of those with financial responsibility on the economic fundamentals. China remains an economy with strong potential for growth. China’s great human talents, its fast-growing technological capabilities, and its further room for “catch-up” growth remain reasons for continued rapid progress. China’s recent efforts to deepen its trade and investment links with the rest of Asia and other parts of the world should be encouraged as win-win propositions.
Yet some market corrections are badly needed. Most importantly, much of the Renminbi appreciation should now be reversed; the currency is overvalued. China’s exports are burdened by an overly strong currency that was pushed too high by the preceding euphoria. Export growth is unduly held back. Yes, some American politicians will complain about “currency manipulation” as the currency weakens, but the drop of the Renminbi will be driven by fundamentals, not manipulation.
A little over a century ago, banking giant JP Morgan stepped forward to quell a financial panic in the New York markets. These days the bankers and hedge fund managers tend to feed panics rather than quell them. We now depend mainly on the central banks and a handful of key politicians at the top to keep their heads, calm their colleagues, and avoid the worst.
The cost of Chinese financial reversal to the real world of jobs and production is still small. Cool heads can keep it that way.
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