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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 an expected phenomenon, but government interference only aggravates them.

China's painful transition to purely market mechanisms
Global financial markets were stirred up due to strong instability on the Chinese stock market. In addition, the yuan is now threatening to fall more than a few percentage points. Some analysts fear a possible collapse of the Chinese economy, which may have global consequences. Some, on the contrary, believe that Beijing intends to take advantage of the depreciation of its currency in order to strengthen exports, and this can cause a wave of competitive devaluations. However, both these positions are generally erroneous.

The current fluctuations in the Chinese stock market are not related to the real state of the Chinese economy, and now, despite the slowdown, no collapse threatens it. In addition, given how much other Asian currencies have depreciated, the moderate decline in the RMB exchange rate can not seriously affect the trade balance. So why did the events affecting mainly China itself shake up global markets?

Some people consider it to be a simple panic reaction. However, judging by the similar fluctuations that took place last summer, the matter is clearly not exhausted. Some blame for what is happening fundamental problems associated with China's reluctance to allow market forces to rule its economy. However, China's economic success was caused precisely by its susceptibility to market reforms. In fact, China is now coming closer to a more "normal", market economy. As well as it is necessary to market economy, it loses ability to manipulate the prices and economic indicators. Combined with globalization, this is what makes China vulnerable to economic cycles.

In essence, China’s current problems stem from the fact that its economy cannot be called either in the full sense of the market or fully controlled by the state. This situation creates uncertainty.

Economic growth in China has slowed for a long time. This is due to a long-term structural transition to growth, based on the services sector, and a short-term cyclical correction caused by the overheating of the real estate market. 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 renminbi with an international status, without waiting for the creation of institutions necessary for this, increased risks and limited the opportunities for maneuver. When the International Monetary Fund approved the inclusion of the yuan in the basket of reserve currencies of special drawing rights, he overly interpreted his own rules, thus rendering China a disservice. One of the two technical requirements for inclusion in this basket implies "free accessibility", which, in general, means the absence of capital controls restricting currency transfers. China clearly does not comply with this requirement.

Chinese firms and households willingly transfer funds abroad, on the background of a transformation of the country from a planned economy with a control of capital into a market economy in which investors can diversify their foreign assets. Accordingly, while the yuan is being crushed by the tendency to depreciation, the "free availability" of currency is practically impossible.

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

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

In addition, the government by its interventions further destabilizes the Chinese stock markets. The Shanghai stock exchange is still dominated by state-owned firms, despite the fact that China's economy is now driven by the private sector.

At the same time, rectilinear 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 for state purchases and a ban on large-scale sales, in fact guaranteed periodic exchange “sales” for the future.

Certain instability is quite an expected phenomenon, but attempts to smooth out the market-induced shifts in the future always lead only to a hard correction. Beijing should allow the stock market to independently find a balance, while strengthening the regulatory and institutional bases, so that in the future, fluctuations occurred primarily under the influence of fundamental economic factors.

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

So far, Beijing is only trying to create a mechanism that allows you to tie the yuan to a currency basket and determine its adequate value. The market signals 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 devalue the yuan much, the actions recently seen by us to counter market factors dragging down the line can hardly be called justified.

The material is published on the website "inosmi.ru" 17 January 2016.
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