The world is in a triangle drama. In one corner, we have slower growth and increased uncertainty in China; in the other, potential rate hikes in the United States; and in the third corner we have emerging market countries, with the clear risk of becoming collateral damage, even if they cannot be described as innocent bystanders. In between these three factors we have the financial markets locked in a pressure cooker.
The World Economic Forum’s Annual Meeting of the New Champions in Dalian took place at a time when China was at the centre of global economic discussion. The move to devalue the renminbi and increasing uncertainty on growth levels have had a major impact on the financial markets. The open discussions and dialogue at the World Economic Forum seem to be increasingly important for business and governments.
For the past four decades it has been taken as given that China will grow at about 10% a year. The country’s transformation, so evident at the ultra-modern conference centre in Dalian, has surpassed everything that mankind has experienced. A country growing at 10% a year for 40 years will increase its GDP by 45 times the original level. Sweden, one of the countries with the fastest industrialization processes in Europe, did the same thing in 155 years.
The International Monetary Fund is forecasting 6.8% growth in China in 2015 and 6.3% in 2016. The population growth, according to the World Bank, is currently at 0.5%, which implies that GDP per capita is growing at nearly 6%. At a growth rate of 6% the GDP per capita would grow from $12,800 today to $22,900 in 10 years and $41,000 in 20 years. This is a fundamental transformation and means that China would become the largest economy in the world during the next decade.
So why all the worry? To start with, it should not be surprising that we see some market turmoil. The renminbi devaluation is, potentially, a major change in China’s economic policy regime, which has been unchanged for decades. It will take time for the markets to learn to understand the new regime and for China’s central bank to develop the necessary tools and instruments to communicate transparently in this new environment.
It is also a significant step in China’s path to opening up the capital account and in the internationalization of the renminbi. It is a necessary step for the currency to be included in the special drawing rights (SDR). To my mind, it is reasonable to include the renminbi in the SDRs as soon as possible, but that also implies that China will have to live up to the obligations that would follow such a move.
An opening of the capital account is a natural step for China and is a part of the reform agenda that was presented at the Third Plenary meeting in 2013. Premier Li Keqiang, in his speech at the meeting in Dalian, reinforced the commitment to deep reforms.
Expansionary monetary policy
A market-based interest rate is necessary to get an efficient allocation of capital. The internationalization of the renminbi and market-based interest rates also imply that monetary policy in China will be on the same footing as in the US, the Eurozone and Japan. The interest rates will eventually be set to uphold price stability and to stabilize demand fluctuations. This will also mean that the renminbi will fluctuate. When China’s economy is slowing down, monetary policy will become more expansionary and that will mean lower interest rates and a somewhat weaker currency. The best service China can do for the world economy is to uphold stable domestic development.
There is always a risk that politics takes the upper hand in currency policy. Many times a currency becomes a symbol for a nation’s strength and any depreciation is seen as problematic or as a part of an international currency war. This is a misperception. Currencies are not involved in the international football championship and there is no need to cheer for the home team. A currency should appreciate when growth is stronger than in other countries and weaken when jobs and exports need some support. Currency policy should be based on pragmatism and realism.
It is important that the opening of the capital account is done gradually and with some caution. In many countries, including Sweden, the move from a regulated capital account to a free flow of capital across borders contributed to economic imbalances. In the long run it was a necessary step, but in the short run the opening of the capital account and deregulation of the banking sector also led to a costly economic boom and bust.
For China the opening of the capital account is complicated in that it coincides with the rebalancing of the domestic economy. Growth has been driven by high investment levels. Particularly after the 2008 crises, the large stimulus programme has pushed up public investments to a very high level that cannot be sustained in the long term. The programme was also heavily skewed towards the public sector, even though the idea of over-investment in a country that still has a couple of 100 million people to urbanize seems to be a strange concept. It is necessary to decrease investments and increase consumption.
The global implication of a lower level of investments in China in the long term is that the excessive demand for commodities, which has driven a boom in countries like Australia, Brazil, Chile and Zambia, is over for the time being. This means iron ore, copper and energy prices are likely to be low for some time. It also has implications for the mining industry and heavy industries which have been dependent on a final demand from China.
For China, it means that the supply-side reforms outlined in the Third Plenary conclusions are even more important. To sustain 6% growth and rebalance the economy from investments led growth without inflationary pressure it is important to increase productivity growth in the domestic economy and to make sure that the economy is flexible enough to adjust. To “ensure that the market has a decisive role in allocating resources in deepening economic structural reform”, as stated in the conclusions of the Third Plenary, is important for the rebalancing of the Chinese economy. Without structural reforms, a rebalancing would come with the risk of slower growth and increasing imbalances.
It is not surprising that there is some uncertainty in international financial markets about whether the government will stick to the reform process. Among the sheltered domestic industries that have lived without market prices for energy and other production factors, there will be political resistance and inefficient industries will have to be restructured, which will not be painless. If the government moves, as is stated in the plenary document, “forward with pricing reform in water, oil, natural gas, electricity, traffic, telecommunications and other such areas, set competitive market prices free”, this will be a major change for the state owned enterprises.
Another factor that may contribute to the uncertainty about the growth level is, somewhat paradoxically, the anti-corruption campaign. A market economy cannot in the long run be legitimate if there is corruption and the credibility of any government is undermined if it is not perceived to be clean. There is, however, a risk that the anti-corruption campaign is seen as a more general authoritarian attitude and as a part of power consolidation. In sectors that have had problems with corruption there is a risk that investment decisions are now delayed or even at a standstill. Given the size of the economy that is directly or indirectly dependent on state-owned enterprises, the impact on the economy can be substantial.
There is an alternative way of fighting corruption and at the same time strengthening the growth potential and that is to move towards a rule of law system. If decisions are made according to clear laws and can be tried in independent courts, the fundamental driving forces behind corruption are reduced. Increased transparency in decision-making and a more open scrutiny of government decision-making would also fundamentally reduce the tendency towards corruption. Harder control can never be as efficient as rule of law when it comes to creating a government and economy that is clean of corruption.
There is also growing political uncertainty in China. The population is increasingly concerned about economic inequality, deep environmental problems – not least connected to air pollution and food safety – and the ongoing corruption scandals. If the answer to these worries boils down to a combination of more authoritarian control and increased nationalism, underpinned with a more pronounced role for the People’s Liberation Army, will a fast-growing aspiring middle class accept this in the long run?
You could argue that the old compromise was that the CCCP keeps the monopoly on power, delivers prosperity and competent governance, but also gradually moves toward increased openness. A gradual move towards greater respect for civil liberties and a gradually broader political conversation seems to have been a reasonable way of meeting a growing class of educated professionals necessary to lift China up the global value chain of production. If the message has shifted toward a stronger emphasis on nationalism and control, that might not be sustainable in the medium term. It is clear that prosperity is created through free trade and cooperation with your neighbours. China needs higher productivity, more innovation, more entrepreneurship and a quantum leap up the value scale. Particularly since a rebalancing from investment-led growth will imply a greater dependence on home-grown productivity increases.
The tension between authoritarian signals and the need for more innovation creates an increased political risk for economic stability. The world needs China to be on a trajectory towards the middle-income society, gradually moving upwards towards more and more knowledge-intensive production and an open-knowledge society, with increased trade and harmonious relations with its neighbours. That is the path to square market uncertainty.
The second partner in the global triangle drama is the United States. The US economy is in recovery. It is natural that higher growth and lower unemployment imply higher inflation and eventually higher interest rates. It is clear that the period of low interest rates and the use of unconventional monetary policy tools are coming to an end. However, there is a risk that raising interest rates in the US could lead to international turmoil.
One side-effect of the regulatory reforms that have been implemented since the Lehman crash is the risk that market liquidity under stress could be lower than policy-makers realize. Global banks have scaled back their role as market-makers and providers of liquidity. To some extent, asset managers have replaced investment banks, but nobody really knows how the new system will work under stress.
At the same time, the central banks have flooded the international financial system with money. When the Federal Reserve, ECB, Bank of England and Bank of Japan are increasing their balance sheets, more money is pushed into the economy. Low yield in the advanced countries has pushed some of this money out in emerging markets. If these investors come running back to the US, there is a risk of excessive volatility. This risk is reinforced by the fact that correlation has increased in the financial markets since 2008. The combination of low liquidity and increased correlation between different markets can be an explosive cocktail.
It is very important that a rise in interest rates in the US is managed in a way that takes the global implications into account. The inflation pressure in the US economy is low and Federal Reserve can afford to move gradually (see my blog, Why the Fed should postpone rate hikes). The world is demanding that China lives up to the obligations that its new role as the second largest economy implies. If so, it is even more important that the world’s largest economy bears the same responsibility. In the decades to come – when China inevitably will play a bigger role – cooperation in the financial system will be increasingly important. There could be long-term repercussions if US monetary policy contributes to a period of instability when China is changing its currency regime. Caution and clear communication is called for.
It is possible that we will have a rather benign economic development in the coming years. If China is growing at about 6% on the back of structural reforms and the US is printing 3% growth with low inflation pressure, this supports a global recovery. The reason the markets are jittery, however, is that there is an alternative scenario that cannot be ignored. If China is slowing more rapidly and inflation forces the Fed to act, we may have a turbulent autumn. Even a moderate depreciation of the renminbi and a moderate appreciation of the dollar could cause large shifts for emerging market currencies.
There are several factors that could lead to turmoil in emerging markets. If investment in China slows down, the impact on growth in emerging markets depending on commodities is disproportionately large. In addition, the turnover on the currency market in many emerging markets is comparatively low in normal circumstances and almost non-existent in a period of high market stress. The Colombian peso, the Indonesian ringgit or the Kenyan shilling, for example, will move disproportionally more than fundamental economic factors would call for. Geopolitical factors in Russia, Brazil and Turkey have also raised the risk level. If we see an emerging market storm building up during the autumn, there is a clear risk that countries like Russia, South Africa, Brazil and Turkey, given that they are adding political uncertainty them self, will get hammered. They are not innocent bystanders, but there will be collateral damage.
Our best hope is that policy-makers stick to their word. If the government in China, as Premier Li underlined in Dalian, reinforces its implementation of structural reforms and the Federal Reserve doesn’t front-load rate hikes, markets will stabilize. To hope for rational policy response is sometimes reasonable, but it is also prudent to prepare for autumn storms.
Author: Anders Borg is a Swedish economist and politician who served as Minister for Finance in the Swedish government. He is the Chair of the World Economic Forum’s Global Financial System Initiative.
Image: A man holding an umbrella walks in front of an electronic stock quotation board outside a brokerage in Tokyo September 8, 2015. REUTERS/Issei Kato