Five things: China’s options

Five things: China’s options

Last week the Federal Reserve once again decided against increasing interest rates, putting the next possible increase off until later this year. Over the months, economists have been bracing themselves for a Fed hike, as Janet Yellen has not been shy in flaunting improvements in US employment – which will eventually lead to greater inflation.

But one fundamental reason which could have motivated the delay is the current state of China’s economy. The Chinese market crashed over the summer and has remained volatile since, and this uncertainty has largely spread across many of other emerging markets. Once the driver of growth in many portfolios, investor sentiment has become increasingly cautious towards emerging markets following the fall of China and slipping commodity prices.

Neil Williams, chief economist at Hermes, encourages Chinese authorities to do more than simply address the symptoms of the falling stocks, and instead focus on the problem of the slowing economy. He says, “China still has a dashboard of policy buttons to press to help achieve a soft landing. Its direct attempts to tackle the symptom have so far failed, so it needs now to address the problem.

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“Over and above reform, the authorities were never going to allow the renminbi to climb indefinitely, as it had been in real weighted terms, at a time when GDP is slowing, and critically China’s competitiveness is collapsing.”

China may not see the 7 per cent growth it was previously boasting any time soon, so it must get used to this new normal. Here are five things you need to know about the economic climate in China.

1. Why did China devalue the renminbi? Devaluing the currency by 3 per cent was meant to influence asset prices, make it more competitive and prevent deflation. It was hoped that this better exchange rate would encourage overseas investors to put money into the Chinese market.

2. Is this 1994 all over again? Not really. For one, the devaluation then was much more significant – the yuan experienced a one-third evaluation then, compared with the 3 per cent renminbi devaluation now, and was motivated more by reforms than by concerns over growth. The Fed tightened rates a month later, and chaos in Asian markets ensued, degenerating into a full crisis by 1997.

China’s recent devaluation combined with speculation of a Fed rate rise has understandably made investors cautious of Asian currencies. However, it is unlikely that a replay of the 90’s will occur even if the Fed does raise rates before the end of the year, as China has much better options to manage volatility now then it did then.

3. What sort of action can China take? Beijing first needs to stop meddling with the market directly. Attempting to re-inflate stocks will do more harm than good. Western investors are not used to governments intervening directly in the market as was the case in China, so this could deter them from further investment.

Mr Williams estimates that stocks in mainland China were supported by $200bn of direct investment before August’s devaluation. This was not sustainable over the long-term, so the motives to weaken the currency should not have been surprising. China is currently running real interest rates of around 4 per cent, so there is room to cut rates if need be. And if that does not work, Beijing could always give a round of QE a try.