openpolitics.com

Sunday’s Financial Times included an article with the following:

Critics of the measures unleashed by Beijing last week argue that they point to a fundamental tension at the heart of China’s political economy that a free-floating renminbi would test even more severely. The ruling Chinese Communist party, they argue, is ultimately incapable of surrendering control of crucial facets of the country’s economic and financial system. As one person close to policymakers in Beijing puts it: “The problem with this system is that it cannot tolerate volatility and markets are all about volatility.”

It’s not just that markets are about volatility. It is that volatility can never be eliminated. Volatility in one variable can be suppressed, but only by increasing volatility in another variable or by suppressing it temporarily in exchange for a more disruptive adjustment at some point in the future.

.. Regulators can never choose how much volatility they will permit, in other words. At best, they might choose the form of volatility they least prefer, and try to control it, but this is almost always a political choice and not an economic one. It is about deciding which economic group will bear the cost of volatility.

But one way or another there will be an enormous amount of volatility within the Chinese economy, not just because it is a relatively poor developing country, which have always been more volatile economically than advanced countries, but also because it is so highly dependent on investment to generate growth. Hyman Minsky argued that economies driven by investment are extremely volatile and overly susceptible to changes in sentiment, and he is almost certainly right.

..  Value investors lack the tools they need to project or value cashflow, and so cannot play their stabilizing role no matter what policy enticements are implemented.

.. Because China’s market is highly speculative, policies that are directed at improving the fundamental value of stocks will have almost no impact on market prices.

.. I suspect, consequently, that the only way to create a credible floor, or to create credible expectations of rising prices, is by “brute force”. Beijing must force entities under its control, or entities it can influence, to buy shares until all uncertainty is removed.

.. But there are three important ways the stock market decline might matter. The first is direct. The combination of the rally and the crash may represent a significant shift in wealth from poorer Chinese to richer Chinese. This must cause total consumption to drop, although the amount will depend on the magnitude of the shift, of which we have no information.

Second, and indirectly, if the market crash causes perceptions of economic uncertainty to rise, households might respond by cutting back on consumption.

Third, and also indirectly, if the crash undermines Beijing’s credibility, or confidence in its ability to manage the economy, it could undermine the financial sector, which relies very heavily on the high credibility Beijing enjoys.

.. China is protected from crisis by its relatively closed capital account, its high level of reserves, and most importantly of all, the fact that much of the mismatch between assets and liabilities are resolved on a system-wide basis through Beijing’s implicit or explicit guarantee of most components of the country’s financial system.

.. One of my Chinese friends complained (although he went long early Thursday afternoon): “It is illegal to sell and illegal not to buy, so how can prices not go up?”

In other words neither fundamental reasons (i.e. improvements in value) nor even technical reasons (i.e. more demand than supply) justify confidence that the panic is over and prices will rise next week. It was as if prices were simply legally required to rise, and so they did, and because this legal requirement cannot last, while technical imbalances still favor selling, you might think that the panic is far from over.

.. Because a well functioning market requires a wide range of investment strategies and, even among investors with similar strategies, it requires information to be interpreted in a wide range of ways. If investment strategies converge, the impact of new information also converges.

China is protected from the risk of financial crisis, in other words, mainly by Beijing’s credibility, which remains very high. Without this credibility, more than three decades of rapid growth accommodated by a financial system designed for credit expansion has left the country with what would otherwise be an extraordinarily vulnerable balance sheet.

.. The next two to three years are vitally important. In the best case scenario, Beijing will continue to rebalance its economy and to restructure the country’s balance sheet and financial system. Yet this cannot happen except under much slower growth. Because the debt will burden will continue to rise for at least another four or five years, Beijing will be tested more than ever. To defend itself from crisis, it must become increasingly stingy with its protection.