Blogs & Comment

Investors have reason to be skeptical about China's economic plan

Time for a sober second look at the factors that caused Monday's flash crash

People's Bank of China Governor Zhou Xiaochuan (Feng Li/Getty)

People’s Bank of China Governor Zhou Xiaochuan (Feng Li/Getty)

At least the headline writers and Twitter wags enjoyed themselves during yesterday’s global financial panic. There was a “Black Monday” tag everywhere you looked, while “The Great Fall of China” (pun intended) was also popular. My personal favourite headline appeared in the print edition of India’s Economic Times: “Don Yuan Causes Heartbreak.”

Oh, has he ever. Trillions of dollars of wealth have been erased since the People’s Bank of China (PBoC) devalued the yuan two weeks ago. The central bank’s move was entirely justifiable. The Chinese economy had been slowing for months, but the country’s currency continued to appreciate as the PBoC sold billions of dollars to buoy the yuan’s value—a gesture few seemed to appreciate. As China’s economy continued to slow, and international investors continued to book profits on their way to the exits, PBoC Governor Zhou Xiaochuan bailed on a losing strategy. That’s what any responsible central banker would have done.

What Zhou failed to take into account was that he hasn’t proved himself a responsible central banker. International investors don’t trust China, nor should they. Beijing operates behind a translucent veil, never entirely explaining its methods. The PBoC described the devaluation as small compared with the yuan’s appreciation in recent years or the depreciation of the currencies of its economic rivals in Asia and Europe. Policy makers pleaded innocence, saying the adjustment was part of a broader strategy to give markets a larger say in the yuan’s value.  Too many investors saw something else: a return to the bad old days of aggressive currency manipulation, evidence that the Chinese economy was much weaker than thought, or both. Cue the panic.

The global stock-market rout culminated with a massive 1,000-point plunge in the Dow Jones Industrial Average when trading commenced in New York on Monday. The unrelenting global financial press compared the unusually extreme trading volatility to every terrible episode in modern financial history—the Asian financial crisis in the mid-1990s, the Black Monday of 1987, and the Black Monday of 1929.

Investors quickly came to their senses, however. Stock exchanges in New York and Toronto pared losses Monday. And on Tuesday, most Asian and European equity markets rallied. The one important exception was China, where the Shanghai Composite Index plunged another 7.6 %. The country’s main stock index has now plummeted more than 20% since Aug. 19, according to Bloomberg News. Zhou responded by cutting interest rates and easing restrictions on bank lending, his latest attempt to restore confidence in the world’s second-largest economy.

It’s always a mistake to attempt to draw conclusions in the middle of a stock-market frenzy, especially in the current financial climate, when so much money is dedicated to trading rather than investing. Black Mondays quickly give way to Turnaround Tuesdays. Take India as an example: the country’s main equity exchanges crashed with those of China, dropping almost 6%, the most since 2008. But as a net importer, India stands to benefit tremendously from the collapse in commodity prices. Companies are becoming more profitable and the economy is gaining a competitive edge on rival emerging markets. Inflation is in retreat and the federal government’s finances are under control. These factors argue against the kind of stock-market retreat that occurred Monday, which explains why Indian markets partially recovered Tuesday.

China’s markets were due for a correction, but a crash feels overdone. There has been a great deal of emphasis placed on China’s poor trade figures, forgetting that it no longer is 2000 and that China has more going for it than exports. One of the more extraordinary events of Monday was Apple Inc. CEO Tim Cook’s email to CNBC host and personality Jim Cramer. Cook told Cramer that iPhone sales in China were “strong” through July and August, and that activations had accelerated in the previous few weeks. An economy that is increasing its consumption of the most expensive smartphone on the market can hardly be considered on the verge of collapse. And even as exports have struggled, a measure of China’s trade in services is at its highest level in almost a year. This is what the country’s leaders—urged on by the International Monetary Fund, the United States Treasury Department, and others—have been trying to achieve: sustainable economic growth supported by domestic demand rather than exports or investment. Weaker exports shouldn’t rattle investors, because that was always part of the plan.

It now is incumbent on Beijing to convince investors at home and abroad that it is serious about sticking to that plan. The PBoC’s latest interest-rate cut was appropriate—any central bank would have responded similarly in the face of such extreme volatility. Chinese officials on Tuesday also put out the word that Beijing was done trying to prop up stock prices with state resources. That could be a difficult promise for the country’s interventionist technocrats to keep. If they manage it, more investors will starting taking China’s government seriously. That would be good for everyone.