Bad news from China doesn’t look like stopping. If the explosion in Tianjin, one of the worst industrial accidents in modern China claiming more than hundred lives and unleashing large-scale cyanide contamination, was not enough, the latest manufacturing index shows factory output having dropped to a low of 77 months. Combined with the fact that net export contribution to GDP growth has been getting lower and lower over time, manufacturing in China is passing through one of its worst phases since the last couple of decades. Doubts are being raised over whether China’s famed manufacturing—reputed for scale, efficiency and broad base—has succumbed to negative externalities from rising wages, poor work conditions in factories and the global slowdown in exports.
Problems are not confined to the health of industry and manufacturing. President Xi’s efforts to reform governance are running into resistance with the entrenched state bureaucracy unwilling to yield turf. This makes the much-awaited organisational reforms of state-owned enterprises (SOEs) a rather distant prospect. On the other hand, debts in Chinese provincial governments are mounting, giving rise to questions on whether provincial debts would become overhangs on a state banking system already burdened by financial repression and large liabilities from the past.
What’s more, for the first time in many years, the world at large appears to doubt China’s ability to prosper, and stay prosperous in the foreseeable future. The changes effected by China to its exchange rate management have put global financial markets into a tailspin. The international financial community appears convinced that the devaluation of the yuan is a last ditch attempt by the Middle Kingdom to kick life into its flagging exports for shoring up the economy. And without bothering to even remotely question the validity of its conviction, the jury appears to be out on the next step: China landing hard with the ‘thud’ being much louder than what many had been anticipating for several years.
It is important to take a deeper and realistic look at what is going in China before subscribing to cynicism and panic. The Chinese economy has undergone enormous structural changes over the last decade making its management exceptionally complex. But this does not imply that the economy has developed vulnerabilities. On the contrary, China’s macroeconomic fundamentals make it one of the safest economies in the world with large amount of liquidity to fight adversities. This is evident from the $4 trillion of reserves held by the Chinese economy—big enough for warding off any speculative unforeseen speculative attacks on the yuan. China’s domestic banking system remains a victim of odd policies: The pressure to practice financial repression through upper ceilings on lending rates and the consequent accumulation of non-performing assets. Even then, the capacity of the Chinese state to recapitalise major state-owned banks for brushing off non-performing loans has not diluted. And as events over the last couple of years show, interest reforms have begun in China along with much tighter scrutiny of projects where banking funds are flowing into.
What China is grappling with is the challenge of meshing its economy that continues to be characterised by non-market institutional and typical ‘Chinese’ features with global markets and institutions that function on different principles. In the process, it is generating shock waves across the world, which is partly unavoidable given the large size and presence it has acquired in global transactions.
The yuan devaluation is the best example. The People’s Bank of China (PBOC) changes the daily system of valuing the yuan from the earlier practice of basing it on a ten-day moving average to the movements of the previous trading day. To many, this would be a more realistic and ‘market-oriented’ manner of fixing the value of the yuan on the immediately preceding spot rates. It is also noticeable that the PBOC is yet to widen the band within which it fixes the yuan, which is at a range of ±2%. The devaluation of August 11, though, after switching to the new system, saw the yuan getting corrected by around 1.8%, stretching the band to almost its maximum. The band might eventually be widened over time and that would give the yuan greater room for correction.
The PBOC’s decision has been commended by many, including the IMF, as a move in the right direction. A more market-based yuan has been a major demand from the international financial community for several years. From a Chinese perspective, a currency taking greater cues from other global currencies, makes it easier to progress towards one of its most challenging macroeconomic goals: freeing transactions on the capital account of the balance of payments. A ‘freer’ yuan also bolsters its claims for joining its other global peers, the US dollar, British pound, Japanese yen and the euro, in the hallowed club of SDR currencies.
So, if China is trying to embrace markets more closely, why is the world getting spooked by that? The problem is the world is not ready to believe that China can get as market-driven as the rest of the world. All are happy to accept and interact with a China that is halfway between controls and markets, since they have got used to doing so. It will take years for the world to get accustomed to doing business with China through real markets.
[The article first published in Financial Express on August 26]
[The author is senior research fellow at the Institute of South Asian Studies in the National University of Singapore.]