Steering Through a Slowdown



China’s Communist Party leaders say they’re learning to love free markets. The world’s starting to learn how much. With an economy sagging under the weight of overcapacity and surging debt, the government is overhauling a financial system built to fuel runaway growth. Its stated method: Give markets a “decisive” role in setting prices and interest rates. Its unstated challenge: Doing it without exacerbating an economic slowdown, triggering panic in global markets or weakening the party’s 67-year grip on power. China’s epic stock market boom and bust revealed it frantically shifting course. The fiddling showed policymakers caught between the desire to embrace elements of capitalism and an instinct to shelve those reforms when things go wrong.







The Situation

The government has jumped in to stem routs in shares and the currency in the past year, executing a series of flip-flops away from market-based policies. Measures to halt the slide in stocks included banning sales by major stakeholders and arming a state agency with funds to purchase equities. China devalued the yuan in August 2015 and pledged to rely more on supply and demand to determine its daily government-set fixing to the U.S dollar. But the move spurred bets on further weakening, prompting the authorities to burn through foreign reserves, enforce stricter capital controls and draft rules for a tax on foreign exchange transactions. Officials also imposed trading curbs on commodities following a frenzied two-month boom and modified rules to increase oversight of state-owned enterprises by the Communist Party. China’s progress toward embracing market forces was acknowledged last year when the International Monetary Fund included the yuan as a reserve currency for global central banks from 2016. On the other hand, MSCI Inc. in June decided not to add mainland China to its benchmark stock indexes. China still limits the amount of yuan that can flow in and out of the country. Most interest rates are now determined by market forces — a cap on the benchmark deposit rate was lifted in October — though the central bank steps in when the money market is hit by bouts of volatility. There are also efforts to extend a government lifeline to heavily indebted property investors, state-owned companies and local municipalities.

The Background

China’s Soviet-style planned economy has been transformed since Mao Zedong derided market-leaning party members as “capitalist roaders” in the 1960s. Today there are more individual stock investors — 90 million — than Communist Party members, and most have less than a high-school education. There’s a shift away from state-directed bank lending and a plan to develop stock and bond markets to fuel growth. At a meeting of party leaders in 2013, policymakers pledged to widen the use of markets, giving them a “decisive” role in allocating resources. They also want to rein in a credit boom and a shadow finance system outside the reach of regulators. The buildup has evoked comparisons with Japan’s debt surge before its real estate and stock market bubble burst in the late 1980s. China isn’t the only country to intervene in times of market meltdown, and central banks around the world have often sought to provide extra funding during times of turbulence. In Europe, some countries temporarily banned short selling during the region’s debt crisis in 2012. Japan tried to stem a stock market slide in 1992 by buying stocks with public funds.

The Argument

The IMF and China’s trading partners argue that the country needs to loosen the guiding hand of the state and better integrate with the world’s financial system. The U.S., which has scolded China on and off for decades for keeping the yuan weak to boost exports, says it must do more to speed reform. China’s intervention in the stock market hurts the credibility of its efforts so far, and is fueling volatility in global markets by sending confusing signals about its intentions. There’s concern about the moral hazard of a hybrid system where investors assume the government will intervene in times of trouble. The support raises questions about the commitment of its leaders to move to a system where money is priced according to risk and allocated via independent forces, rather than channeled to support asset prices or state-owned enterprises at the government’s bidding. They are well aware that moving too quickly to loosen controls, or mishandling the process, could spur turmoil.

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