Ste­phen Roach: Stop worry­ing about Chi­na.

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Fe­ars of a Chi­ne­se mel­tdown are vast­ly over­blown. But Chi­na will ne­ver suc­ceed if it does not bring its fi­nan­ci­al sys­tem in li­ne with its eco­no­my, ar­gues Ste­phen Roach.

Sin­ce the be­gin­ning of 2016, the pro­s­pect of an eco­no­mic mel­tdown in Chi­na has be­en sen­ding tre­mors th­rough glo­bal fi­nan­ci­al mar­kets. 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. Ul­ti­mate­ly, this mis­match bet­ween pro­gress in eco­no­mic re­b­a­lan­cing and set­backs in fi­nan­ci­al re­forms must 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 per­cent ex­pan­si­on in the ser­vice sec­tor outs­trip­ped that of the on­ce-do­mi­nant ma­nu­fac­tu­ring and con­struc­tion sec­tors, which to­ge­ther grew by just 6 per­cent last ye­ar. The ser­vice sec­tor ro­se to 50.5 per­cent of Chi­ne­se GDP in 2015, well in ex­cess of the 47 per­cent sha­re tar­ge­ted in 2011, when the 12th Fi­ve-Ye­ar Plan was ad­op­ted, and ful­ly 10 per­cen­ta­ge points lar­ger than the 40.5 per­cent sha­re ma­de up by 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 per­cent mo­re jobs per unit of out­put than ma­nu­fac­tu­ring and con­struc­tion, the ser­vice sec­tor’s re­la­ti­ve strength has play­ed an im­portant ro­le in li­mit­ing un­em­ploy­ment and preven­ting so­ci­al in­sta­bi­li­ty — which has long be­en 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 10 mil­li­on and a slight in­crea­se from 10.7 mil­li­on in 2014.

The bad news is that Chi­na’s im­pres­si­ve head­way on re­struc­tu­ring its 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 bank­centric 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), Chi­na’s vul­nera­bi­li­ty can hard­ly be igno­red. But at $3.3 tril­li­on by the end of 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 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 first hand 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 stock 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.

Ste­phen Roach, the for­mer chair­man of Mor­gan St­an­ley Asia and the firm’s chief eco­no­mist, teaches ma­nage­ment at Ya­le Uni­ver­si­ty.

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