Harvard Professor Jeffrey Frankel: China Confronts the Market

CAMBRIDGE – China’s current economic woes have largely been viewed through a single lens: the government’s failure to let the market operate. But that perspective has led foreign observers to misinterpret some of this year’s most important developments in the foreign-exchange and stock markets.

To be sure, Chinese authorities do intervene strongly in various ways. From 2004 to 2013, the People’s Bank of China (PBOC) bought trillions of dollars in foreign-exchange reserves, thereby preventing the renminbi from appreciating as much as it would have had it floated freely. More recently, the authorities have been deploying every piece of policy artillery they can muster in a vain attempt to moderate this summer’s plunge in equity prices.

But some important developments that foreigners decry as the result of government intervention are in fact the opposite. Exhibit A is the August 11 devaluation of the renminbi against the dollar – a move that invoked for US politicians the old adage, “Be careful what you wish for.” The devaluation – by a mere 3%, it should be noted – reflected a change in PBOC policy intended to give the market more influence over the exchange rate. Previously, the PBOC allowed the renminbi’s value to fluctuate each day within a 2% band, but did not routinely allow the movements to cumulate from one day to the next. Now, each day’s closing exchange rate will influence the following day’s rate, implying adjustment toward market levels.

The authorities probably would not have moved when they did had it not been for growing market pressure for a depreciation that could help counteract weakening economic growth. In fact, bolstering growth might have been the primary motivation for the country’s political leaders, even as the PBOC remained focused on advancing the longer-term objective of strengthening the market’s role in determining the exchange rate.

But the two motivations are consistent: market forces would not be placing downward pressure on the renminbi if China’s economic fundamentals did not warrant it. The American politicians who demanded that China float its currency may have anticipated a different outcome – somewhat unreasonably, given that market forces reversed direction in mid-2014 – but one can hardly blame the Chinese for taking them at their word.

To be sure, China remains far from embracing a free-floating currency, let alone a fully convertible one, which would require further liberalization of controls on cross-border financial flows. Unification of onshore and offshore markets is more important than a floating exchange rate in determining whether the International Monetary Fund will include the renminbi in the basket of currencies used to determine the value of its reserve asset, the Special Drawing Right. Much commentary on the subject has underestimated the importance of the criterion that the currency be “freely usable.”

Nonetheless, many are fretting that China’s exchange-rate adjustment has triggered a “currency war, ” with other emerging economies devaluing as well. But, more than a year after the economic fundamentals swung against emerging markets (and especially away from commodities) and toward the United States, this adjustment was due. Though the Chinese move likely influenced the timing, other devaluations would have inevitably taken place. Warnings about competitive devaluations are misleading.

Exhibit B in the case against attributing financial developments in China to government intervention is the stock-market bubble that culminated in June. According to the conventional wisdom, the authorities consistently intervened not only to try to boost the market after the collapse, but also during its year-long run-up, when the Shanghai Stock Exchange composite index more than doubled. The finger-wagging implication is that Chinese policymakers, particularly the stock-market regulator, have only themselves to blame for the bubble.

There is undoubtedly some truth to this story. It seems clear that the extraordinary run-up in equity prices was fueled by a surge in margin financing of stock purchases, which was legalized in 2010-2011 and encouraged by the PBOC’s monetary easing since last November. Likewise, there was plenty of support for the bull market in government-sponsored news media, for example.

But what many commentators fail to note is that China’s regulatory authorities took action to try to dampen prices over the last six months of the run-up. They tightened margin requirements in January, and again in April, when they also facilitated short-selling by expanding the number of eligible stocks. The event that ultimately seems to have pricked the bubble was the China Securities Regulatory Commission’s June 12 announcement of plans to limit the amount that brokerages could lend for stock trading.

This is precisely the kind of counter-cyclicalmacroprudential policy that economists often recommend. But, whereas advanced economies rarely implement this advice, China and many other developing countries do tend to adjust regulation, including reserve requirements for banks and ceilings on homebuyers’ borrowing, counter-cyclically.

One could criticize the Chinese regulator on the grounds that the effect of its moves to increase margin requirements did not last long; or one could criticize it on the grounds that its moves caused the recent crash. But, either way, these measures were intended to stem the rise in market prices, rather than to contribute to it.

This is not a trivial point. Nor is the fact that the PBOC’s interventions in the foreign-exchange market over the last year have aimed to dampen the renminbi’s depreciation, not add to it. Given this, it is facile to blame China’s problems on government intervention.

Copyright: Project Syndicate 2015 – China Confronts the Market