China’s economic dynamics
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The author is a professor of finance at Peking University and a senior researcher at the Carnegie-Tsinghua Center for Global Policy
This Confused The Chinese stock market intensified last week as foreign investors dumped Chinese stocks, making Beijing’s regulators scrambling regain confidence And they are trying to stabilize the domestic market. But if foreign investors become more cautious about investing in Chinese stocks, this may actually be a good thing for China.
In the past two years, capital inflows to China has soared by more than US$30 billion per month. Part of the reason is that the country’s monthly trade surplus has increased by US$10 billion per month, and capital inflows have increased by US$20 billion per month. This trend is expected to continue. Despite Beijing’s domestic savings surplus, in recent years it has opened up its financial markets to unrestricted inflows of foreign capital. This is mainly to gain an international reputation for these markets and promote the use of the renminbi in the world.
But this prestige comes at a price. As long as it refuses to re-impose capital controls-which would undermine years of gradual opening-Beijing can only adapt to these inflows in three ways. Each will bring its own costs, and as foreign inflows increase, this cost will be magnified.
One way is to allow foreign demand for the renminbi to continue to rise, thereby pushing up its value. Of course, the problem is that this will damage China’s export sector and encourage further inflows, thereby pushing China’s huge trade surplus into a deficit. If this happens, China will have to reduce its total production (thus reducing GDP growth).
The second way is for China to intervene to stabilize the value of the renminbi. In the past four years, China’s currency intervention has not been conducted directly through the People’s Bank of China but indirectly through state-owned banks. They have accumulated more than US$1 trillion in net foreign assets, mainly in the past two years.
However, large-scale currency intervention is incompatible with domestic currency control, because China must create a renminbi for the purchase of foreign currencies. As the People’s Bank of China has warned many times this year, the consequences will be the rapid expansion of domestic credit and the deterioration of domestic asset bubbles.
Many readers will realize that these are just versions of the central bank’s trilemma: If China wants to open its capital markets, it must give up control over currency or domestic money supply. However, Beijing can respond to these capital inflows in a third way, which is to encourage the Chinese to invest more overseas, so that the net inflow will decrease due to the increase in outflows.
And this is exactly what regulators have been working hard to do. Since October last year, they have implemented a series of policies to encourage Chinese people to increase overseas investment, not only institutional investors and companies, but also families.
But even if these policies are successful (so far they have not been successful), this will bring a series of risks. In this case, foreign institutional investors who put hot money into liquid Chinese securities are balanced with Chinese entities that invest in various assets overseas for various purposes.
This will leave China with a typical developing country problem: international balance sheet mismatch. This increases the risk that foreign investors may withdraw suddenly if Chinese investors are unwilling or unable to repatriate their foreign investment to the country quickly enough. We have seen this situation many times before: the shaky financial system supported by state-backed moral hazard is forced to adapt to the surge in hot money inflows, but cannot adjust quickly when hot money flows in and out.
As long as Beijing wants to keep its capital markets open, it can only respond to inflows through a combination of three: the destructive appreciation of the currency, the excessive growth of domestic money and credit, or the risk of its international balance sheet. There is no other choice.
This is why the current stock market turmoil may be a blessing in disguise. To a certain extent, foreign investors are more cautious about the influx of Chinese securities and reduce the inflow of foreign hot money, thereby reducing the pressure on the financial authorities to choose among these three bad choices.
Before carrying out a substantial clean-up and transformation of its financial system, in other words, Chinese regulators should be more concerned about foreign purchases of its stocks and bonds, rather than buying too few.