China can’t peg its policies to the stock market index

Sure enough, when 2016 trading opened on Monday, January 4, the Shanghai A share market fell 7 per cent (and again on Thursday, January 7), dragging global stock markets with it. The dominant story in 2015 was the slowdown of the Chinese economy and its impact on global commodity prices, including demand on luxury goods. Would this trend continue into 2016? 

The IMF 2015 Article IV consultation on China, arguably the best available official “health-check report”, commented in August that China was “transitioning to a new normal, with slower yet safer and more sustainable growth”. Growth in 2014 fell to 7.4 per cent and was forecast to slow further to 6.8 per cent in 2015. Sure enough, by October, the IMF World Economic Outlook forecast was 6.3 per cent for 2016, not bad by any standards, but slower than that for India (7.5 per cent), currently the darling of foreign investors.  

There are good reasons for being cautious amid the rising risks. The international media’s analyses of the Chinese economy are almost uniformly pessimistic. Not only do they think that there will be a hard landing but several analysts reckon a financial crash is inevitable.  

The facts are quite clear on the risks. Firstly, between 2008 and 2014, China’s private debt-to-GDP ratio rose by 73 percentage points. In their 2009 book “This Time is Different”, Reinhart and Rogoff famously suggested that fast-rising private debt was the best indicator of financial crises and that in the last five years Chinese debt had grown fastest relative to total debt. Secondly, China’s economy is clearly slowing, with both manufacturing and service sector indicators showing shrinkage or deceleration. Thirdly, since July last year, despite market intervention, China’s stock market index has been dropping. Bank of America Merrill Lynch analysts are predicting a Shanghai Composite Index level of 2,600 for 2016, compared with peak levels of 5,178 in June last year and current levels of 3,100. Fourthly, there are capital outflows and concerns on renminbi depreciation. 

On the plus side, proponents argue that so far, the labour market has remained resilient because of the shift towards a more labour-intensive service sector. Household consumption has remained fairly firm, while inflation has been flat, helped by lower commodity and energy prices.  

Unlike in advanced countries, Chinese fiscal policy has much more room to manoeuvre, because total government debt was still less than 60 per cent of GDP at the end of 2014. By allowing more interest rate and exchange rate flexibility, room for monetary-policy manoeuvring by the People’s Bank has been strengthened. Despite concerns about the rising level of non-performing loans, the largely state-owned Chinese banking system has adequate capital to absorb these, and those of the shadow banks, which are slowly but surely being brought within the regulatory network. According to the latest available data, credit and total social financing has decelerated, but there are no signs of abnormal illiquidity or debt deflation, since the property market has shown some signs of uptick in first-tier cities.

On the external front, the balance of payments current account remains in surplus at 2.1 per cent of GDP, which offset the capital outflows as indicated by the loss in foreign exchange reserves.  

Because its economy is so large, looking at China requires a longer-term perspective than normal. The “new normal” is that the Chinese economy is slowing naturally as the economy grows larger and the median age of the populace increases. Under the 13th Five Year Plan, the economy is being retooled to become driven by domestic consumption, innovation and services – an open economy that aspires to social inclusivity and environmental sustainability.  The mantra on the supply-side adjustment is all about getting rid of excess manufacturing capacity and moving to energy and resource efficiency. 

Meanwhile several developments imply that China will contribute towards global public goods – among them the Asian Infrastructure Investment Bank, the renminbi becoming an international reserve currency, Chinese aid to Africa and its global climate change initiatives. 

All these aspirations must be achieved within the context of social and financial stability. No economy in the world has attempted all these ambitious goals simultaneously without some trade-offs. In such a massive transformation in scale within so short a timeframe, some economic, financial or political pain is inevitable.  

Seen from this perspective, the key question for China is whether the economic trajectory is “J”- or “L”-shaped. In other words, are the reforms aiming for a short correction followed by more sustainable long-term growth, or will China join the rest of the world in a global secular stagnation phase?  

China’s debt problem is almost unique in that it is largely a domestic debt overhang, with state-owned banks lending mostly to state-owned enterprises and with no net debt owing to foreigners. I have argued that, since Chinese local governments and state-owned enterprises still own considerable net assets, now is the time to rewrite the national balance sheet with debt-equity swaps to cut back the debt and restore balance in the corporate leverage situation. The state-led system can deal with its state-driven debt problem.  

But one factor to consider in the current system is whether the political cycle is in sync with the economic cycle. Beijing’s anti-corruption campaign, which is designed to restore integrity and trust in the cadre system, has now pulled in a number of businessmen, which creates uncertainty whether public and investor confidence will be “business as usual”.   

The level of the stock market index is only an indicator of the complex mix of investor greed and fear. Just as GDP is no longer adequate as a benchmark of economic progress, policies and business decisions benchmarked against a stock market index can only be wrong.

Tough decisions will have to be taken in 2016 to ensure that the long-term aspirations of the 13th Five Year Plan can be achieved.          

 

Andrew Sheng is a distinguished fellow at the Asia Global Institute, University of Hong Kong.