China's cur­rency sta­bil­ity fo­cus is a dis­trac­tion

The Pak Banker - - OPINION - Rob John­son

CHINA'S man­age­ment of ex­change rate peg con­tin­ues rat­tle global fi­nan­cial mar­kets. On­go­ing un­cer­tainty about ren­minbi de­val­u­a­tion is fu­elling fears that de­fla­tion­ary forces will sweep through emerg­ing mar­kets and de­liver a body blow to de­vel­oped economies, where in­ter­est rates are at or near zero (and thus can­not be low­ered to de­fend against im­ported de­fla­tion).

Fis­cal grid­lock in both Europe and the US is height­en­ing the angst. But the cur­rent bout of ex­change-rate anx­i­ety is re­ally just a symp­tom of the fact that China's tran­si­tion from an ex­port-led growth strat­egy to one pro­pelled by do­mes­tic con­sump­tion is pro­ceed­ing far less smoothly than hoped.

For some peo­ple, vi­sions of the won­ders of cap­i­tal­ism with Chi­nese char­ac­ter­is­tics re­main undi­min­ished. They are cer­tain that, af­ter more than three decades of state-di­rected growth, China's lead­ers know what to do to turn their slump­ing econ­omy around.

The op­ti­mists' un­re­al­ity is ri­valled by that of sup­ply-siders, who would ap­ply shock ther­apy to China's slump­ing state sec­tor and im­me­di­ately in­te­grate the coun­try's un­der­de­vel­oped cap­i­tal mar­kets into today's tur­bu­lent global fi­nan­cial sys­tem. That is a pro­foundly dan­ger­ous pre­scrip­tion.

The power of the mar­ket to trans­form China will not be un­leashed in a stag­nant econ­omy, where such mea­sures would ag­gra­vate de­fla­tion­ary forces and pro­duce a calamity. The per­sis­tent down­ward pres­sure on the its to ren­minbi re­flects a grow­ing fear that Chi­nese pol­i­cy­mak­ers have no co­her­ent so­lu­tion to the dilem­mas they face. Float­ing the ren­minbi, for ex­am­ple, is a dan­ger­ous op­tion.

Af­ter all, with the Chi­nese econ­omy un­der­go­ing whole­sale eco­nomic trans­for­ma­tion, es­ti­mat­ing a long-term equi­lib­rium ex­change rate that will an­chor spec­u­la­tion is vir­tu­ally im­pos­si­ble, par­tic­u­larly given per­sis­tent doubts about data qual­ity, dis­clo­sure, and opaque pol­i­cy­mak­ing pro­cesses.

But if the cur­rent ex­change rate peg to a bas­ket of cur­ren­cies fails to an­chor the ren­minbi and pre­vent sharp de­pre­ci­a­tion, the de­fla­tion­ary con­se­quences for the world econ­omy will be pro­found. More­over, they will feed back on the Chi­nese ex­port sec­tor, thus damp­en­ing the stim­u­la­tive im­pact of a weak­ened cur­rency.

The key to sta­bil­is­ing the ex­change rate lies in creat­ing a cred­i­ble devel­op­ment pol­icy. Only then will the pres­sure on the ren­minbi, and on China's for­eign-ex­change re­serves, sub­side, be­cause in­vestors both within and out­side the coun­try will see a clear way for­ward. Es­tab­lish­ing pol­icy cred­i­bil­ity will re­quire di­min­ish­ing the mud­dled mi­croe­co­nomic in­cen­tives of state con­trol and guar­an­tees. It will also re­quire rein­vig­o­rat­ing ag­gre­gate de­mand by tar­get­ing fis­cal pol­icy to sup­port the emerg­ing eco­nomic sec­tors that will un­der­pin the new growth model.

But, as usual with China, such a strat­egy is rid­dled with con­tra­dic­tions. For ex­am­ple, re­duc­ing the size of the state-en­ter­prise sec­tor is nec­es­sary, yet would be cer­tain to de­press ag­gre­gate de­mand at a time when de­mand is al­ready soft. Like­wise, cutting fis­cal sup­port (via gov­ern­ment-di­rected bank lend­ing) to zom­bie firms would free up fis­cal ca­pac­ity and en­able re­sources to be redi­rected to new sec­tors that fa­cil­i­tate ser­vices and ur­ban em­ploy­ment; but this would ex­ac­er­bate - at least at first - today's de­mand short­fall.

Slash­ing the state sec­tor abruptly and ex­pect­ing to achieve trans­for­ma­tion through aus­ter­ity is not the way for­ward. Eco­nomic his­to­ri­ans, no­tably Michael A. Bern­stein in his study of the Great De­pres­sion in the US, have con­vinc­ingly shown that an econ­omy in tran­si­tion re­quires strong ag­gre­gate de­mand to pull re­sources into new sec­tors.

If both the old and new sec­tors of an econ­omy are in a slump, cap­i­tal for­ma­tion will sput­ter, in­vest­ment in up­grad­ing hu­man cap­i­tal will de­cline, and struc­tural ad­just­ment will stall. Ro­bust ag­gre­gate de­mand is al­ways essen­tial to suc­cess­ful trans­for­ma­tion.

An equally large ob­sta­cle to China's eco­nomic tran­si­tion is the wide­spread wor­ship of China's hy­brid mar­ket econ­omy. Sim­ply put, today's mud­dled mar­ket in­cen­tives im­pede trans­for­ma­tion by favour­ing state-owned en­ter­prises.

In early 2012, when the Chi­nese lead­er­ship moved to­ward stronger pri­vate own­er­ship, stocks in the pri­vate-sec­tor subindex out­per­formed the state-owned sec­tor subindex on both the Shang­hai and Hong Kong stock ex­changes. But since the spring of 2014, this trend has re­versed, and the state-owned sec­tor subindex has out­per­formed the pri­vate-sec­tor subindex. As the Chi­nese econ­omy slows and de­fault risk grows, the value of state guar­an­tees rises, di­rect­ing cap­i­tal away from pri­vate sec­tor growth.

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