How a Great Power Falls Apart
Decline Is Invisible From the Inside
August was an abysmal month for China’s capital markets. The country’s stock market fell 11 percent and is down a cumulative 40 percent from its June peak. The yuan, which the Chinese government has historically controlled so tightly, also made an unprecedented slide. Its two percent depreciation on August 11 was the largest one-day drop Beijing has permitted since 1994, when it first set a single exchange rate against the U.S. dollar. The yuan depreciated another one percent the next day. Although financial turmoil is not always a cause for concern, this episode coincides with signs of a worsening economic slowdown in China. A financial market correction, which provides rare, unfiltered data on China’s economy, is especially noteworthy given the deep-seated skepticism with which outside observers (and China’s leaders, too) view the country’s official economic data.
For those inclined to believe that China’s growth miracle has run its course, it is easy to draw eerie parallels between China in August 2015 and the United States at the onset of its financial crisis in the fall of 2008. Both suffered financial shocks, lagging growth, and housing market downturns. But the parallel is flawed—China is not experiencing a “Lehman shock.” Instead, its stock market meltdown and currency devaluation are likely the consequences of deliberate economic policy decisions made recently in Beijing. These choices are making China's capital markets more global and weakening the government's grip over them.
Take the “Shanghai–Hong Kong Stock Connect,” for example. Chinese securities regulators introduced this program last November to open up the Shanghai stock market to significant inflows of foreign capital. The initiative followed China’s standard, incremental approach to economic reform. Foreign ownership of mainland stocks was initially capped at under two percent of the Shanghai market’s tradeable shares, but could have easily been raised if the policy was successful. Soon after China opened the door to inflows of foreign cash, mainland investors opened 50 million new accounts between November 2014 and the end of June 2015. As a result, stock prices rose a staggering 150 percent between early 2014 and June 8, 2015.
The euphoria broke the next day on June 9, when MSCI, a major compiler of global stock indices, issued a decision about whether it would included Chinese stocks traded in Shanghai in its indices. If MSCI had added Chinese stocks, it would have encouraged the developed-world pension funds, mutual funds, and sovereign wealth funds to buy them, spurring a potentially huge flow of foreign capital into the Chinese stock market. Instead MSCI refused, citing its concerns about the opaque controls that China imposes on foreign capital. Three days later, the stock market peaked. Between then and the end of August, the Shanghai Composite Index fell by nearly 40 percent. Despite government interventions requiring state-owned investors to buy shares to prop up stock prices and controls preventing many investors from selling, there was no stopping the financial meltdown. Beijing’s very success in drawing outside investors, both Chinese private investors and foreigners, into the stock market in 2015 sharply weakened its control over the market’s behavior.
China's stock market meltdown and currency devaluation are likely the consequences of deliberate economic policy decisions that China has made recently, which are making its capital markets more global and weakening its grip over them.
Similarly, it was Beijing’s push to secure a global role for its currency that ultimately led it to allow the yuan’s sudden depreciation. Since the global financial crisis of 2008 and 2009, the Chinese government has been promoting the yuan as a global currency in order to reduce China’s dependence on the U.S. dollar in global finance. To encourage widespread acceptance of its currency, it has offered yuan-denominated swap lines to non-Chinese central banks as a hedge against future financial turmoil. It has also promoted the use of the yuan as a payment currency for businesses engaged in international trade and encouraged transactions denominated in its currency “off-shore” in Hong Kong’s yuan-denominated bond market. Most recently, China’s government has been attempting to persuade the International Monetary Fund to include the yuan in the Special Drawing Rights (SDR) basket of reserve currencies, which currently includes the U.S. dollar, the euro, the British pound, and the Japanese yen. China believes that inclusion in the SDR basket will encourage sovereign wealth funds, central banks, and comparable public entities to hold the yuan in their reserve assets.
This policy initiative has come into conflict with China’s tight control of its exchange rate. To promote foreign use of the yuan, Beijing has permitted increasingly free flows of capital across its border. Since 2014, free flows have meant free outflows: Between June 2014 and August 2015, China’s foreign reserves fell by a massive $436 billion or over 10 percent. Non-political macroeconomic forces are behind this drop: Chinese export growth in 2015 is the weakest since the great recession, China’s central bank has cut interest rates five times since November 2014, and the U.S. Federal Reserve is preparing to raise interest rates. All these developments encourage capital outflows. To slow that outflow, it appears that China allowed the yuan to devalue, in part, to correct the currency’s increasing overvaluation relative to non-dollar currencies, which have depreciated more than 20 percent against the dollar since mid-2014.
Market forces must play a more decisive role if China is to transition out of an unsustainable dependence on exports, capital investment, and housing bubbles. As that process goes on, the rest of the world will have little choice but to adjust to periodic episodes of global tumult triggered by China’s quest to find a new financial identity.
On August 11, the same day the yuan’s fall began, China’s central bank announced a new exchange-rate policy that could soon move the yuan much closer to a market-determined (and far more volatile) exchange rate: China’s central bank, the People’s Bank of China, will continue to limit daily exchange rate fluctuations to a narrow two-percent range above or below the “central parity rate” that it announces each morning. But it has also pledged to set the central parity rate according to both financial market conditions and the price at which the currency was traded in capital markets the day before. The new exchange rate mechanism looks like a response to the IMF’s decision against adding the yuan to the SDR basket in 2015: Since IMF rules require SDR basket currencies to be “freely traded,” a classification that makes it all but closed to tightly managed currencies like the yuan, a more market-determined Chinese exchange rate is likely a precondition for the yuan’s inclusion in the SDR basket. Although the People’s Bank of China has not yet permitted the yuan to depreciate further against the dollar than it did on August 12—and claims there is “no basis for further depreciation”—China’s ambition to play a larger global financial role will pressure its government to allow additional devaluation and exchange rate volatility in the months ahead.
China’s waning control over its stock and currency markets has certainly produced a stomach-wrenching spectacle, but its fallout for the real economy looks manageable. Unlike in the United States, where a severe stock market correction could spread to credit markets and prevent businesses from securing loans or consumers from securing mortgages, China’s credit supply is dominated by state-controlled banks. This blocks the channel through which stock market panic could infect other parts of the financial sector or the real economy. In addition, stocks comprise a smaller share of Chinese household wealth than in the United States, limiting the risk that consumers will cut spending as stock prices fall. And if the yuan does indeed depreciate further in coming months, it will likely do more good than harm to the Chinese economy. A weaker yuan would support the export sector and help China save their reserves as insurance to hedge the risk that the country’s long, slow deceleration turns into a scarier downturn. Perhaps most importantly, China’s government still controls the levers it used to spur an economic boom in 2008 and 2009. If 2015’s slowdown becomes more severe, officials could easily direct state-owned firms to launch another investment spending spree with the funding of state-controlled banks (Wisely, they have not done so).
This summer’s wave of financial volatility does not signal the end for the Chinese economy. But it does reveal that if Beijing wants to internationalize its currency, secure a role in the international financial system commensurate with its share of the global GDP, and escape the unipolar influence of the U.S. dollar on international finance, it can no longer retain the top-down control it has historically exercised over its economy and financial system. That will mean more market corrections and financial volatility in China than in the past. But this is actually good news for the country’s long-term economic prospects. Market forces must play a more decisive role if China is to transition out of an unsustainable dependence on exports, capital investment, and housing bubbles. As that process goes on, the rest of the world will have little choice but to adjust to periodic episodes of global tumult triggered by China’s quest to find a new financial identity.