China Seeks Cure for Economic Downturn After Missteps Spook Investors

An analysis by Michael Lelyveld
2016-01-19
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china-economy-01192016.jpg An investor looks at an electronic board showing stock information at a brokerage house in Shanghai, Jan. 18, 2016.
AFP

China's regulators are reeling with the effects of the country's latest stock market crisis amid signs that the damage to the investment environment could last for years.

Confidence in the Chinese economy has come under strain following the government's report Tuesday that gross domestic product (GDP) rose at a 6.9-percent rate in 2015, the slowest pace in 25 years.

The official GDP estimate barely qualified as meeting the government's target of "about 7 percent," while institutions including the World Bank and the International Monetary Fund have forecast further slippage in 2016.

Fourth-quarter growth faded to 6.8 percent, the National Bureau of Statistics (NBS) reported, in a sign of the weakening trend.

Investor confidence in China has already suffered a serious blow at the start of the year, based on stock market performance alone.

In the first trading week of 2016, the Shanghai Composite Index plunged 10 percent in sessions shortened twice by major "circuit breaker" suspensions. By the end of last week, the Shanghai market was down over 18 percent.

Despite rallying Tuesday on stimulus hopes after the GDP numbers came out, Shanghai stocks have still lost 15 percent on the year so far.

Global reverberations

On the other side of the planet, the Dow Jones Industrial Average fell 6.2 percent in the first week, despite the lack of direct exposure to China's fledgling market and support from a strong U.S. report on new jobs.

The Dow has notched a year-to-date loss of 8.2 percent loss as of last Friday, driven by weaker-than-expected lending figures from China and plummeting oil prices.

Unpredictable crisis management in China has left both markets on unsteady ground.

Aside from the stunning 7-percent drops in share prices on Shanghai and Shenzhen exchanges before the circuit breakers stopped trading twice in the first week, several separate concerns have spooked investors abroad.

First was the fear that China's markets might reflect greater weakness in the economy than portrayed by the official figures.

"It has been obvious for a while that China's economy is in big trouble. How big is hard to say, because nobody believes official Chinese statistics," wrote economic columnist Paul Krugman in The New York Times.

Then came concerns that the People's Bank of China (PBOC) was simultaneously devaluing the currency, as the yuan declined 1.5 percent against the U.S. dollar during the first week after falling 4.3 percent last year.

"Why would you want your currency to fall?" asked David Wessel, senior fellow in economic studies at the Brookings Institution in Washington, speaking on PBS News Hour. "Well, the only reason you'd want your currency to fall... is in order to get more exports."

Consumer spending worries?

But Wessel noted that China's stated policy is to rely less on exports as it pursues its transition to a consumption-led economy.

"They must be worried about consumer spending not being as strong as they thought," he said.

On Friday, Premier Li Keqiang denied the devaluation was part of an export strategy, arguing that there is "no basis" for continued depreciation, state media reported.

But perhaps the most unsettling factors were the lack of transparency and frequency of regulatory changes during the market crisis and a similar crash last July and August.

The China Securities Regulatory Commission (CSRC) suspended its poorly-conceived circuit breaker rule just days after it was imposed, saying it "didn't work as anticipated based on actual situations."

Investors had rushed to sell ahead of the cutoff, creating pent-up selling pressure when trading restarted. The result was a stampede.

In a panic, the CSRC also slapped restrictions on selling by major shareholders almost as quickly as it had removed them earlier in the week.

Investors relying on consistency in regulation and policy making looked in vain to find it.

"The market's message was loud and clear, that more clarity and less flip-flopping is needed going forward," said Singapore's DBS Bank as quoted by Reuters.

On Monday, the CSRC denied a Reuters report that the authority's chairman, Xiao Gang, had offered to resign.

Lock-up share rules

Rules on "lock-up shares" for trading by major shareholders, initial public offerings (IPOs) and the direction of the yuan have all been on watch for changes from
one day to the next.

Despite assurances that the market would not affect the broader economy, the uncertainty over regulation has raised concerns about stability, said Gary Hufbauer, senior fellow at the Peterson Institute for International Economics in Washington.

"This has done a lot to erode confidence in the management of the Chinese economy," Hufbauer said in an interview.

China has been gradually opening its financial markets in keeping with recommendations from the International Monetary Fund and major trading partners, including the United States, said Hufbauer. But China's leaders have appeared unprepared for the results.

"When you open financial markets to external and internal forces, you're going to get more ups and downs than if you control everything," Hufbauer said. "The Chinese authorities have a hard time accepting that."

There has been little clarity on whether the PBOC has been trying to push the yuan lower with its daily midpoint fixings or simply reacting to offshore currency trading. But analysts agree that China's inconsistent stock market interventions have made matters worse.

"It all looks pretty amateur hour, and that's not how the Chinese authorities want to seem," Hufbauer said.

While heavy buying by state funds may restore calm temporarily, as it did during last year's crisis, the damage to investment is likely to be longer term.

Foreign investors already in China are expected to stay put, but new investment could be deterred for "a year or two at least," Hufbauer said.

Further yuan decline seen

He noted a Goldman Sachs forecast that the yuan will decline further, touching 7 to the U.S. dollar within a year, from about 6.5 yuan to the dollar now.

"If the yuan is gradually devaluing, why go in with your investment now? Why not wait?" he said.

So far, foreign direct investment (FDI) is one of the few markers of the Chinese economy that has held up relatively well.

Last year, non-financial FDI in China rose 6.4 percent to U.S. $126.2 billion (835.2 billion yuan) after gaining just 1.7 percent in 2014, the Ministry of Commerce said.

Even without direct connections between China's stock markets and the larger economy, the panicky conduct of policy may tip the balance against investment decisions that are already close calls.

In a press briefing at the New York-based Council on Foreign Relations on Jan. 6, senior fellow Sebastian Mallaby cited at least five different policy responses by regulators, aimed "just simply at stifling the market instability."

Arguably, the over-regulation sent a signal to investors that there could be more heavy-handed approaches to come.

China's stock market may be unreliable as an economic indicator, since it is dominated by small investors rather than financial firms.

But in the current environment of slowing growth, high debt and a weakening yuan, the market is more likely to be reflecting rising economic concerns.

Mallaby said that China's economic growth and investment are linked in a "feedback loop" that may lead to accelerating declines after years of expansion.

"This positive feedback loop between growth and investment could be a negative one, where all of a sudden, growth slows, so that justifies less investment, that investment means less growth, less growth means less investment," he said.

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