False Alarm on China

NEW HAVEN – The prospect of an economic meltdown in China has been sending tremors through global financial markets at the start of 2016. Yet such fears are overblown. While turmoil in Chinese equity and currency markets should not be taken lightly, the country continues to make encouraging headway on structural adjustments in its real economy. This mismatch between progress in economic rebalancing and setbacks in financial reforms must ultimately be resolved as China now enters a critical phase in its transition to a new growth model. But it does not spell imminent crisis.

Consistent with China’s long experience in central planning, it continues to excel at industrial reengineering. Trends in 2015 were a case in point: The 8.3% expansion in the services sector outstripped that of the once-dominant manufacturing and construction sectors, which together grew by just 6% last year. The so-called tertiary sector rose to 50.5% of Chinese GDP in 2015, well in excess of the 47% share targeted in 2011, when the 12th Five-Year Plan, was adopted, and fully ten percentage points larger than the 40.5% share of secondary-sector activities (manufacturing and construction).

This significant shift in China’s economic structure is vitally important to the country’s consumer-led rebalancing strategy. Services development underpins urban employment opportunities, a key building block of personal income generation. With Chinese services requiring about 30% more jobs per unit of output than manufacturing and construction, combined, the tertiary sector’s relative strength has played an important role in limiting unemployment and preventing social instability – long China’s greatest fear. On the contrary, even in the face of decelerating GDP growth, urban job creation hit 11 million in 2015, above the government’s target of ten million and a slight increase from 10.7 million in 2014.

The bad news is that China’s impressive headway on restructuring its real economy has been accompanied by significant setbacks for its financial agenda – namely, the bursting of an equity bubble, a poorly handled shift in currency policy, and an exodus of financial capital. These are hardly inconsequential developments – especially for a country that must eventually align its financial infrastructure with a market-based consumer society. In the end, China will never succeed if it does not bring its financial reforms into closer sync with its rebalancing strategy for the real economy.

Capital-market reforms – especially the development of more robust equity and bond markets to augment a long dominant bank-centric system of credit intermediation – are critical to this objective. Yet in the aftermath of the stock-market bubble, the equity-funding alternative is all but dead for the foreseeable future. For that reason alone, China’s recent financial-sector setbacks are especially disappointing.

But setbacks and crises are not the same thing. The good news is that China’s massive reservoir of foreign-exchange reserves provides it with an important buffer against a classic currency and liquidity crisis. To be sure, China’s reserves have fallen enormously – by $700 billion – in the last 19 months. Given China’s recent build-up of dollar-denominated liabilities, which the Bank for International Settlements currently places at around $1 trillion (for short- and long-term debt, combined), external vulnerability can hardly be ignored. But, at $3.3 trillion in December 2015, China’s reserves are still enough to cover more than four times its short-term external debt – well in excess of the widely accepted rule of thumb that a country should still be able to fund all of its short-term foreign liabilities in the event that it is unable to borrow in international markets.

Of course, this cushion would effectively vanish in six years if foreign reserves were to continue falling at the same $500 billion annual rate recorded in 2015. This was precisely the greatest fear during the Asian financial crisis of the late 1990s, when China was widely expected to follow other so-called East Asian miracle economies that had run out of reserves in the midst of a contagious attack on their currencies. But if it didn’t happen then, it certainly won’t happen now: China’s foreign-exchange reserves today are 23 times higher than the $140 billion held in 1997-98. Moreover, China continues to run a large current-account surplus, in contrast to the outsize external deficits that proved so problematic for other Asian economies in the late 1990s.

Still, fear persists that if capital flight were to intensify, China would ultimately be powerless to stop it. Nothing could be further from the truth. China’s institutional memory runs deep when it comes to crises and their consequences. That is especially the case concerning the experience of the late 1990s, when Chinese leaders saw firsthand how a run on reserves and a related currency collapse can wreak havoc on seemingly invincible economies. In fact, it was that realization, coupled with a steadfast fixation on stability, that prompted China to focus urgently on amassing the largest reservoir of foreign-exchange reserves in modern history. While the authorities have no desire to close the capital account after having taken several important steps to open it in recent years, they would most certainly rethink this position if capital flight were to become a more serious threat.

Yes, China has stumbled in the recent implementation of many of its financial reforms. The equity-market fiasco is especially glaring in this regard, as was the failure to clarify official intentions regarding the August 2015 shift in exchange-rate policy. These missteps should not be taken lightly – especially in light of China’s high-profile commitment to market-based reforms. But they are a far cry from the crisis that many believe is now at hand.