Making Sense of the Market Turmoil

Global stock markets stabilized somewhat on Tuesday following two trading days of sharp declines, calmed in part by an interest rate cut by China’s central bank following a further 7.6 percent decline in the Shanghai index earlier in the day. With underlying forces still putting pressure on global equity prices, the volatility could well continue for some time, and this could have implications for economic growth and policy in China, the United States, and beyond.

Q1: What explains the recent turmoil in global financial markets?

A1: A critical part of the story no doubt is anxiety about China's economic trajectory. The economy has been slowing for the past two-plus years, and there are reasonable worries that the official growth rate is inflated above actual performance. The government has been trying to walk a fine line between encouraging growth and implementing structural reforms, but has evidently not been very successful at either. Moreover, much of the recent stimulus has been “nutrient-light,” that is, freeing up capital for bets in the stock market instead of encouraging greater productivity. The bungling over managing the volatility of China's stock market, the mixed signals sent in regarding to moving the renminbi (RMB) toward a managed float, the handling of the chemical accident that claimed over 100 lives in the large port city of Tianjin, delays over issuing reform plans for state-owned enterprises (SOEs), and worsening strains in U.S.-China relations have all contributed to growing doubts about the capacity of the country's current leadership and China's future course.

While events in China may be the precipitating factor behind the market turmoil, broader forces are also at play. International investors are responding to a divergence in growth prospects and political stability between the emerging world (not just China but other major economies such as Mexico, Turkey, and Indonesia) and the advanced world, particularly the United States. U.S. growth has been weaker than in past recoveries but strong enough to feed perceptions that the Federal Reserve may soon begin to “normalize” monetary policy, raising interest rates and drawing in international capital searching for better returns than available in Europe, Japan, or emerging economies. Concerns about the post-crisis growth of global debt and excessive dollar borrowing by emerging economies have also likely fueled the volatility.

Q2: How are governments responding?

A2: China's initial response to the massive fall in its stock markets on Monday was to pretend nothing happened. The Party's flagship newspaper, the People's Daily, had zero coverage on the stock market, and the official Xinhua news agency had a tiny story that was purely factual and drew no wider implications. But on Tuesday, Premier Li Keqiang spoke on the record to try and reassure the public that China's economic fundamentals were still solid and that economic reforms were still on track. At the same time, the People's Bank of China announced three steps: the one-year benchmark deposit rate was cut 25 basis points, from 4.85 percent to 4.60 percent; the reserve requirement ratio (RRR) for banks was cut 50 basis points, from 18.5 percent to 18.0 percent; and the ceiling interest rate for savings deposits longer than one year was lifted. These steps are not aimed directly at supporting the stock market, but instead directed at providing more liquidity to the broader economy. In July, China witnessed an estimated $70 billion in capital outflows. The macro effect has been contractionary, and the RRR cut alone is estimated to free up about $100 billion for banks to be able to lend.

While the Chinese government has intervened to avoid a further tightening of the macro economic environment, it has not taken steps to overtly support stock prices other than suggesting that the national pension fund could invest up to 30 percent of its holdings in the market. The lack of commitment to maintain stock prices is a significant change from policy steps in early July. It appears now that central authorities may allow the Shanghai and Shenzhen markets to find their "natural" bottom. Conversely, it appears that for now the government does not want to see the RMB exchange rate fall much further. Premier Li on Tuesday said he does not believe further depreciation is warranted. If investors in and outside China disagree, this may set up a test of wills, with the Chinese government forced to defend the RMB and provide domestic liquidity or allow a larger depreciation and face criticism from the U.S. and others.

The Obama Administration has said it is monitoring the situation but not announced any new policy steps; however, behind the scenes, the U.S. Treasury is in close consultation with the Chinese authorities and counterparts in other major economies. The market turmoil is likely to dominate discussions among G20 finance ministers when they meet in Ankara on September 4-5, but it is unclear what new measures they can announce to calm the markets beyond credibly reaffirming their commitment to generating sustainable growth. Meanwhile, despite prominent calls for it not to raise rates at its regular meeting next month, the Federal Reserve Board is likely to look through short-term volatility and consider the longer-term inflation, employment, and financial stability outlook in deciding when to begin normalizing U.S. monetary policy.

Q3: Could this undermine China’s growth, reform, and even political stability?

A3: There are excellent reasons why China's long-term growth prospects are still solid. A lot of bright human capital remains under-utilized and reforms of the financial system, education, and state-owned enterprises could still yield a big growth dividend. But between now and the long-term sits the short-term, and Chinese authorities have to guide the economy through these short-term dangerous straits before focusing on the long-term. The next major reform item on the agenda is for state-owned enterprises (SOEs). We should watch closely whether the plans are geared toward making SOEs more cohesive internally and more responsive to their state masters or whether they are forced to accept greater competition from private and foreign rivals.

The problems in the economy and mismanagement of the stock market may result in a few mid-level officials losing their jobs—the most vulnerable seems to be stock market regulator Xiao Gang—but it's far too premature to talk of a split between Xi Jinping and Li Keqiang. And certainly the overall leadership of the Communist Party is secure. Even if the stock market crisis turned into an all-out financial crisis, the Party would still have many tools at its disposal to limit the economic damage and maintain its authority.

Q4: What are the broader implications of the market volatility?

A4: The recent market turmoil is more a symptom than a cause of broader problems in the global economy: it reflects the weak and uncertain growth outlook across major markets that has persisted since the global financial crisis of 2008-2009; the International Monetary Fund has repeatedly downgraded its forecast for 2015 growth, most recently to 3.3 percent. However, the blow to confidence from equity market volatility could further cloud the growth outlook. Moreover, short-sighted policy responses, such as beggar-thy-neighbor currency devaluations, could undermine global economic and financial stability.

Expectations for President Xi's state visit to Washington, D.C., in late September were already extremely low. China's economic challenges mean that the leadership will be even more focused on domestic affairs and even less likely to be willing to make any concessions on issues of importance to the United States, including on cyber, the South China Sea, and human rights.

Matthew P. Goodman is the William E. Simon Chair in Political Economy and senior adviser for Asian economics at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Scott Kennedy is deputy director of the Freeman Chair in China Studies and director of the Project on Chinese Business and Political Economy at CSIS.

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