The vertiginous fall in Chinese stock markets in the first week of the new year is a timely reminder of a key risk in 2016. Data suggesting that China's growth is, indeed, slowing was the proximate cause of the financial market volatility. That wasn't (or shouldn't have been) news. The fear might be that the path from high growth to lower growth may pass through negative territory.
While economists don't always agree, there is, I suspect, a strong consensus that, as a first approximation, the Solow growth model is a good framework for understanding long-term growth. And one of the key results of that model is poorer countries with lower capital-labor ratios can grow more rapidly than richer countries with higher capital-labor ratios through investment. That, clearly, has been China's story over the past three decades — high domestic savings financing high investment. But after 30 years of high investment that has brought a wall of labour from the farms to the cities and gradually raised wages, it is becoming more difficult to find high return investment opportunities. That, too, is part of the Solow story: as growth progresses and differences in capital-labor ratios narrow, growth slows.
We have seen this story play out before. The Stalinist growth model of the 1950s achieved impressive results as capital was thrown into the mix with labour. Over time, however, additional investment didn't have the same effect; eventually, the Soviet economy stalled, leaving the moribund economy inherited by Gorbachev. To some extent, the Asian financial crisis may have reflected a similar process — high investment rates that led to high growth rates, which over time resulted in lower returns. This is not to suggest that China is inevitably headed for a similar denouement, only that slower growth should not have been "news."
So, what is going on?
Good question. Although I don't pretend to definitively know the answer, I can take a guess.
With growth slowing, investors reevaluating stock market valuations —"priced," as the old line goes, "not only for the future, but the hereafter" — chose fear over greed and decided to get out. But as investors (the "smart money") started exiting the market, a prudent reduction in exposure suddenly became a panicked rush for the exits, illustrating once again the fallacy of liquidity the investor's assumption that you will always be able to liquidate your position before the next trader catches on. In the event, circuit breakers introduced by the authorities tripped and trading was suspended.
Now, in principle, a suspension of trading may be a sensible response to an avalanche of information (precipitous price drops) that fuels feedback trading, whether by automated trading programs or by individual investors. Information overloads can impede efficient price discovery and masks underlying values as markets jump from one equilibrium to another. Such rules can be useful, for example, in halting bank runs and the liquidation of bank assets at fire sale prices, which validate the panicked response of depositors to fears of insolvency. A suspension of bank deposit convertibility (or announcement of bank holidays) will likely only be effective in calming depositors if the bank truly is solvent and can credibly be proven so, or the authorities intervene, through capital injections, say, to make it solvent. If that isn't the case, the run will resume once the temporary suspension is relaxed.
The key point here is the credibility of actions taken to calm the panic.
The Chinese authorities' response to recent stock market turbulence has been met with more than a little skepticism by markets. To some extent, this reflects unease with the opaque nature of policy making — a point implicitly recognized by the creation of a new policy making body. In this regard, the authorities' initial response to the market disruptions seems to impose restrictions on sales. The problem with this approach is that, while the measure may help stem the price collapse, investors are unlikely to buy if they can't sell. If they can't get their money out, they won't put their money in. This underscores the importance of legal and other policy frameworks.
As China's importance to the global economy rises and financial integration with the rest of the world increases, uncertainty regarding policy frameworks will have bigger effects. Greater clarity and stability of policy regimes should anchor expectations and reduce volatility. That is good for the short term.
At the same time, stable policy frameworks and strong institutions can have beneficial long-terms effects. Brad DeLong of Berkley argues strong institutions that protect property rights and promote innovation and entrepreneurship represent the "secret sauce" of long-term growth. Societies that foster technological innovation and efficient resource allocation can escape the tyranny of declining growth; that may explain the remarkable record of growth and high GDP per capita of the advanced economies.
It takes time to develop domestic institutions and stable policy frameworks and sovereign states jealous of their independence are loath to allow others' rules and institutions to apply. Yet, that is sometimes the case. Consider, for example, countries that use the dollar. More often than not, however, countries choose to build their own institutional and legal frameworks. International institutions can help in the process of institutional development. International financial institutions can help authorities tie themselves to sound policy frameworks and strong institutions and thereby allow countries to sustain growth and make continued progress on poverty alleviation.
Investors wary of ‘Hotel California’ markets, in which they can check in but never check out, will not make long-term investments in innovation that can help sustain growth and dampen the effects of convergence; they will, rather, opt for the short-term bet to avoid being caught up by unanticipated changes in the legal, regulatory or policy environment.
