August 19, 2015    3 minute read

Does China Know What it is Doing?

   August 19, 2015    3 minute read

Does China Know What it is Doing?

China’s ruling party claims to be a Communist party, but in reality the economy is one where some consider ‘crony capitalism’ to be rife. Up to this point the world assumed that the nation’s leaders were aware of this – that they know better than to actually believe their occasional socialist rhetoric. However, the uncertain and ever-changing policies of the past few months suggest something somewhat worrying. It could be possible that the Government does not fully understand markets and how they work.

The root of the problems lie in the fact that there a great degree of unbalance in the Chinese economy with a very low share of GDP devoted to consumption and a very high share devoted to investment. This was sustainable while the country was able to maintain rapid growth; but growth is slowing as China runs out of surplus labour. As a result, returns on investment are declining quickly. There is a need to invest less and consume more. There has to be policies which distribute the benefits of growth more widely. The problem is arises in the manner by which they sustain spending during the transition.

At first, there was a large amount of infrastructure spending by the Chinese government. This took the form of cheap credit to State-owned enterprises. The result was an increase in enterprise debt, which by last year was high enough to raise worries about financial stability. After this came the official stock stock price boosting policy: stock-buying propaganda alongside relaxed margin requirements, making it easier to buy stocks with borrowed money. The consequence was an obvious bubble, which began deflating earlier this year.

In an attempt to control this, the government took drastic action: suspending trading in many stocks, banning short-selling, pushing large investors to buy. This worked for a period of time but it is at the cost of tying China’s credibility to its ability to keep stock prices from ever falling. This is all while the Chinese economy still has inherent instability and needs support.

This week China decided to let the value of its currency decline, which made some sense: the renminbi was undervalued five years ago, it is significantly overvalued now. The authorities had the arrogance, or perhaps ignorance, to believe that they could control the devaluation.  They were wrong. They appear to have been taken completely by surprise by the market’s predictable reaction: the initial devaluation of the renminbi was the first in a series, a sign of much bigger declines to come. Investors began fleeing China.

The recurring issue in these policy swings is that the Chinese government believes that it can control markets. It believes it can tell what prices to reach and when. This is not how the system works. If Chinese leaders really don’t understand markets, that is a big concern. China is an economic superpower — not quite as super as the United States or the European Union, yet, but big enough to matter, a lot. Its also facing tough times. So if its leadership is as clueless as it has been looking lately, that bodes badly, not just for China, but for the world as a whole.

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