Markets need timeout on China

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Markets need timeout on China

On the way to remaking China’s economy, President Xi Jinping has hit many roadblocks: vested interests, a change-averse Communist Party, local officials accustomed to the status quo. Who knew the real barrier would be foreign investors?

For years, the world has called on China to loosen its grip on the yuan, drop its arbitrary growth targets, allow stocks to fall, attack corruption and let reckless borrowers suffer losses. But whenever Beijing has taken any of these steps, global investors have responded with fear and trembling.

Wall Street’s sudden turn for the worse doesn’t have anything to do with China’s economic fundamentals. News emerged last Friday that China’s manufacturing activity had fallen to a six-year low - but that was entirely consistent with reams of recent data showing weak industrial production, retail sales, inflation and rental rates. Investors can’t be shocked to hear that China’s 7 percent growth rate in the first six months of 2015 was the slowest in six years.

The real trigger for market turmoil was China’s Aug. 11 devaluation. But China shouldn’t be blamed for investors’ hypocritical response. A more market-determined exchange rate had long topped the China wish list of everyone from U.S. President Barack Obama to the International Monetary Fund to London hedge funds. When China obliged, markets succumbed to panic. The same goes for China’s recent decision to allow market forces to drive down the Shanghai composite index (down a combined 15 percent Monday and Tuesday).

It’s true that China is a pretty dismal communicator. “Markets,” says economist Arthur Kroeber of Gavekal Dragonomics, “trade as much on policy signals as on economic reality, and there has clearly been a breakdown of communication between Beijing and the rest of the world.” But it was still clear enough that Beijing’s policy makers weren’t really panicking - if they were, their 3.1 percent devaluation would’ve been closer to Kazakhstan’s recent 20 percent drop.

China’s slowdown has been the most telegraphed by any major economy in decades. But as soon as Xi seemed sincere about making good on his rhetoric about a “new normal” and markets playing a “decisive role” in the economy, investors screamed for him to stop. Markets are sending a clear message to Xi’s government: More growth, less of this messy reform stuff.

Investors’ abandonment of nuance has left China in a bind. China’s obsession with global clout has been driving its effort to get the yuan counted among the IMF’s five reserve currencies. Xi’s priority for the next 12 months can be summed up with three words: stability, stability, stability. So we shouldn’t be shocked if China responds to the recent market turmoil by shelving its reform efforts and clamping down more on the public’s personal freedoms.

“What is increasingly apparent is that China’s leaders want the economic growth that capitalism produces, but without the downturns that come with it,” writes Richard Haass, president of the Council on Foreign Relations in a Project Syndicate op-ed. “They want the innovation that an open society generates, but without the intellectual freedom that defines it. Something has to give.”

With the vertiginous plunge in Shanghai shares and “Chinese crisis” headlines spanning the globe, Beijing has seen what happens when it cedes control to markets. It’s telling that China waited until Tuesday - after it had already been blamed for crashing global markets - to cut interest rates (for a fifth time since November) and relax banks’ reserve requirements.

By staging tantrums at the first sign of reform, investors are making it more difficult for Beijing to take steps toward becoming a more sustainable economy. Investors should stop treating China like a gargantuan, 1.3 billion-employee company with a duty to constantly surprise to the upside, and start showing a more nuanced appreciation for China’s situation. If international financiers want China to accept the pros and cons of market forces, they should acknowledge that getting there will require painful and destabilizing policy changes.

Nervous investors should start by taking a deep breath. If you think the Dow is a poor barometer of America’s long-term economic health, there’s little reason to treat the present value of Shanghai shares as a meaningful indication of China’s economic future.

Of course, there’s plenty of scope to criticize China on trade, piracy, human rights and pollution. But let’s remember how daunting its economic challenges are: It needs to shift growth engines from excessive investment and exports to services; confront giant state-owned enterprises that prefer the country’s nepotistic status quo; and deflate bubbles in debt, stocks and property amid weak global growth. If investors were true to their capitalist commitments, they would admit Shanghai shares need to fall much further to match Chinese fundamentals. Even after the recent bloodbath, Shanghai trades at 15 times earnings, almost twice the ratio in Hong Kong.

China has a long and treacherous road to travel. Xi’s job is precarious enough without impatient global investors acting as backseat drivers.

*The author is a Bloomberg View columnist based in Tokyo and writes on economics, markets and politics throughout the Asia-Pacific region.

by William Pesek

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