This week’s dramatic declines in the Chinese stock market follow similar episodes last summer – both saw huge losses in market value accompanied by a depreciation of the yuan. In each instance, the financial turmoil in China sent assets in other markets around the world tumbling. But could there be global economic upside to these events?
Such financial upheaval has generated despair and frustration among Chinese investors, as many individuals and households have seen their investments evaporate, with share prices dropping dramatically from last year’s peak. The government has banned large shareholders from selling off their holdings.
Elsewhere, the reaction to China’s stock crashes and currency depreciation ranges from concern to panic. It is widely believed that these are symptoms of serious problems in the Chinese economy and a signal of more substantial slowing of its growth than the world anticipated.
While these troubles are indeed bad news for China and the world in the short term, it may have a positive longer-term effect. The crisis China faces today could be one of the last straws that break the back of political resistance to much-needed structural reform.
Underlying the turbulence in the Chinese stock market is both the slower speed of economic growth (which, at 6 to 7 per cent, may be low by Chinese standards, but not compared with most other economies), as well as the deteriorating quality of growth in recent years. China’s investment-driven development model, exacerbated by massive government stimulus, has led to excessive capacities, stockpiles of unsold goods and property and increasing risks of a debt crisis.
Without fundamental structural reforms, even if the government can maintain a certain rate of GDP growth through further use of monetary and fiscal instruments, it will only kick the can down the road, postponing its day of reckoning. The gross inefficiency in the allocation of resources will ultimately undermine the long-term sustainability of the Chinese economy, with negative ripple effects for the rest of the world.
Chinese policy makers have recognized the shortfalls of the old development model for more than a decade. Since the early 2000s, Chinese leaders have called for a shift to a new development model based more on domestic consumption and less on investment and exports. However, due to strong resistance from powerful vested interests, change has been slow and hesitant. Since 2013, bold measures have been announced by the government to “deepen economic reforms,” increasing the role of market forces in the allocation of resources, including capital, and exposing state-owned enterprises to more domestic and international competition. However, to the disappointment of many observers, few of these reform measures have been implemented. In the absence of a major crisis, Beijing has been content to take a path of least resistance in the realm of structural reform.
The worsening situation of the Chinese economy, amplified by the financial-market downturn of late, has mixed effects on the important issue of structural reform. On the one hand, the government has been under great pressure to calm financial markets. During the stock-market crash last summer, it brought in a so-called national team – a coalition of state-controlled financial institutions – to buy shares, and banned large shareholders from selling off their holdings. This week, Chinese regulators implemented a new (but short-lived) “circuit-breaker” that automatically suspended trading when the market fell by more than 7 per cent. After markets reopened, they again shut down when stocks took another big tumble. Rather than getting out of the market, the government increased its intervention.
The serious financial and economic woes of recent months have greatly increased the stakes and urgency of reform. Herein lies a potential silver lining for the dark cloud.
In December, the Chinese Communist Party held an economic work conference, which explicitly emphasized the need to carry out “supply-side structural reform.” Earlier this week, the party’s newspaper carried a much-noted interview with an individual sourced only as an “authoritative figure,” who stressed that the time has come to reduce excessive capacity, to withdraw life support for inefficient enterprises and projects and to let market forces play a decisive role in the allocation of resources. The source recognized that the process would be painful, but argues it is inevitable, and that the Chinese economy will come out of this process with new vigour.
One can hope, cautiously, that the recent crisis serves as an impetus to overcome some of the tough political obstacles for further economic reform.