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China's painful transition to purely market mechanisms

Mr. Juan is a Senior Fellow at the Carnegie Endowment and former head of the World Bank Country Office in China

Fluctuations in the markets are expected, but government intervention only exacerbates them.

China's painful transition to purely market mechanisms
The global financial markets have been shaken by the strong volatility in the Chinese stock market. In addition, the yuan is now in danger of falling by more than a few percentage points. Some analysts fear a possible collapse of the Chinese economy, which could have global consequences. In contrast, some believe that Beijing intends to take advantage of the depreciation of its currency to bolster exports, which could trigger a wave of competitive devaluations. However, both of these positions are generally wrong.

The current fluctuations in the Chinese stock market are not related to the real state of the Chinese economy, and at present, despite the slowdown in growth, it is not threatened with any collapse. In addition, given how much other Asian currencies have depreciated, a moderate depreciation of the yuan cannot seriously affect the trade balance. So why did events that primarily affect China itself shake global markets so much?

Some consider this to be a simple panic reaction. However, judging by the similar fluctuations that took place last summer, this clearly does not end there. Some blame fundamental problems related to China's reluctance to allow market forces to rule its economy. However, China's economic success was driven precisely by its susceptibility to market reforms. In fact, China is now moving closer to a more "normal", market economy. As befits a market economy, it loses its ability to manipulate prices and economic indicators. This, combined with globalization, is what makes China vulnerable to economic cycles.

In essence, China's current problems stem from the fact that its economy can neither be called a fully market economy nor fully state-controlled. This situation creates uncertainty.

Economic growth in China has slowed for a long time. This is due to a long-term structural transition to service-led growth and a short-term cyclical correction caused by the real estate market overheating. Many hoped that the process would go smoothly, but the factors shaping these trends suggest that we should still expect instability.

Beijing's actions further complicated the situation. His desire to provide the yuan with international status, without waiting for the necessary institutions to do so, increased risks and limited room for maneuver. When the International Monetary Fund approved the inclusion of the yuan in its SDR basket, it over-interpreted its own rules, doing China a disservice. One of the two technical requirements for inclusion in this basket is “free availability,” which in general means no capital controls limiting currency transfers. China clearly does not meet this requirement.

Chinese firms and households are willing to transfer funds abroad, amid the country's transformation from a centrally planned economy with capital controls to a market economy in which investors can diversify their overseas assets. Accordingly, as long as the tendency towards depreciation presses on the yuan, "free availability" of the currency is practically impossible.

In the past, these pressures were generally mitigated by the fact that profits in China were much higher than overseas. Real estate prices rose, and in addition, the yuan pushed up the trade surplus.

However, now economic growth has slowed down, property prices are falling, the yield gap is narrowing, and this dictates a different logic of action to Chinese firms and households. Accordingly, it is becoming more difficult for Beijing to liberalize its financial markets. As a result, instability is growing.

In addition, the government by its interventions additionally destabilizes the Chinese stock markets. The Shanghai Stock Exchange continues to be dominated by state-owned firms, even as China's economy is now driven by the private sector.

At the same time, straight-line investors with the mentality of gamblers influence exchange fluctuations more strongly than fundamental economic indicators. After the summer collapse, the government, which artificially supported prices with state purchases and a ban on large-scale sales, virtually guaranteed periodic stock market “sales” for the future.

A certain volatility is quite an expected phenomenon, but attempts to smooth out the shifts that arise under the influence of market forces in the future always lead only to a severe correction. Beijing should allow the stock market to find equilibrium on its own, while simultaneously strengthening regulatory and institutional frameworks, so that in the long term, fluctuations occur primarily under the influence of fundamental economic factors.

Dealing with volatility in the foreign exchange market will be more difficult. China is moving away from pegging to the US dollar and moving to a more flexible system of pegging the yuan to a currency basket. If Beijing succeeds, the yuan will become stable against this basket, but the exchange rate against the dollar will be able to fluctuate more freely. This is a smart way to move towards a floating exchange rate, which is impossible for China at the current stage of financial development.

So far, Beijing is only trying to create a mechanism to peg the yuan to the currency basket and determine its adequate value. The market is signaling that this will require devaluation, but the question is how strong it should be. If it is moderate, the process can be carried out gradually. However, if it is necessary to greatly devalue the yuan, the actions we have seen recently to counter market factors pulling the rate down can hardly be called justified.

The material was published on the website "" on January 17, 2016.
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