Thursday, January 7, 2016

China learns a costly lesson

The problem with China is not that the economy is collapsing, it is that the government is reluctant to let markets work. Bureaucrats and statists like to think that they know best, that markets are flawed and need limits and controls, but that's just hubris to the max. Markets aggregate the wisdom of millions when setting prices, and prices in turn send vital signals which help keep an economy running smoothly.

Government intervention in markets invariably results in unintended consequences, and China's "circuit breaker" on their stock market is only the latest example. When market participants are told that markets will shut down if stocks drop more than 7%, that only intensifies the desire to sell, as investors scramble to get out before the door shuts. The best way to keep capital in a market is to let capital know that it is free to leave whenever it wants. Turn off the circuit breakers and watch the market sort itself out!

Fortunately, China's securities regulator this morning announced the suspension of its circuit breaker program; bureaucrats learned a tough but important lesson. Although this is likely to provoke another stampede for the exits (after all, they might decide to reinstate the circuit breaker), in time the market—if left alone and given the proper assurances—will find the price that restores equilibrium. 

But it's not just the securities market that is having trouble, it's also the foreign exchange market, since the central bank is trying to fix the yuan's price with discreet adjustments to the yuan instead of allowing the currency to float freely. Eventually they will find the right price, but only at the cost of sowing uncertainty and squandering reserves. If the price of the yuan is too high, then the central bank will only fritter away its reserves trying to defend the price. That's what has been happening for the past 18 months, as China's forex reserves have dropped from $4 trillion to $3.33 trillion as of the end of December '15, and the central has been forced to cut the yuan's value from 6.05 to 6.59 per dollar. 

Markets are very powerful forces, and the Chinese economy and its markets are now so large that the government has essentially lost the ability to manage things according to bureaucrats' whims. This is good news for the long haul, but expect to see further dislocations along the way, because bureaucrats are loathe to give up their power.

Here's a quick look at how things stand.

The chart above shows the value of the yuan (blue) and the level of the central bank's foreign currency reserves (red). In a pegged currency regime such as China's, the central bank must purchase any net inflow of foreign currency. China enjoyed huge net inflows of capital for most of the past two decades because the economy was booming and foreign investors were eager to join the party. The central bank purchased some $4 trillion of foreign currency during this time, and that served to expand China's monetary base, essentially converting dollars into yuan to support a rapidly expanding economy. But the boom times are over, and capital flows began to reverse a year or so ago. The central bank was slow to react, however, and so it had to sell almost $600 billion of its reserves to defend what is now an "overvalued" yuan from the market's perspective. They don't want to do this forever, however, and so the decision to "devalue" the yuan back in August, and now to accelerate the decline of the yuan peg. Sooner or later they will find the right value of the currency which balances capital flows and restores confidence to the forex market, but it's an agonizing process. Better to just let the yuan float.

The chart above shows the inflation-adjusted value of the yuan vis a vis its trading partners, as of the end of November. Here we see that despite the August devaluation, the yuan was still very strong, having effectively appreciated by almost 100% since early 1994. Since November the yuan has dropped another 3% against the dollar, so I figure the yuan is now about 2-3% below its all-time high in real terms. That's not a collapse by any measure; the yuan is still one of the world's strongest currencies. It will probably decline further, especially if the government keeps trying to control the decline by selling reserves and doesn't allow a free float. But this should all be seen in the light of the economy's transition from rapid growth to more moderate growth. And in the context of powerful markets teaching hubristic bureaucrats a lesson.

The chart above shows the Shanghai Composite index. Note that even after the recent sharp decline, stocks are still more than 50% above their value as of 18 months ago. What was crazy was the huge runup in stocks from mid-2014 to mid-2015, during which time stocks rose some 160%.

China is going to eventually figure things out, and the economy is not going to collapse.


marcusbalbus said...

singing a diff tune now grannis. and its ironic you talk of manipulated markets considering what the the US does w central bank policy and the bail outs.

Scott Grannis said...

Not exactly. I've consistently said that the Fed was not manipulating the bond market (i.e., not artificially depressing long term interest rates). Rather, I've argued that QE was mainly about transmogrifying notes and bonds into T-bill equivalents in order to satisfy the demand for safe assets. I believe the Fed has no ability to artificially depress bond yields. In fact, the evidence shows that bond yields rose during each of the three QE episodes.

It also bears noting that the Fed makes no attempt to target the dollar's exchange rate.

I've never defended the bail outs, and never would. I have no qualms about blaming bureaucrats and politicians for many if not most of our problems.

I've been writing about problems in China for some time now:

Benjamin Cole said...

IMHO a great post

One observation: I think Scott Grannis is right, and that if the yarn floats it will depreciate as it has actually been over valued.

This will make China-produced goods even cheaper for the world.

The US Federal Reserve has a rare opportunity to gun the presses hard in an aggressive move to promote growth. We are seeing the buildup of deflationary forces.

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