News about the Chinese economy
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The author is a finance professor at Peking University and a senior fellow at the Carnegie-Tsinghua Center for Global Policy
The chaos in China’s stock markets over the past week was compounded by the sale of Chinese stocks by foreign investors, so Beijing regulators struggled to regain their confidence while trying to stabilize domestic markets. But if overseas funds become more cautious about investing in Chinese stocks, it could actually be good for China.
In the past two years, inflows into China have increased by more than $ 30 billion per month. This is partly due to a monthly increase in the country’s monthly trade surplus of $ 10 billion and a monthly increase in financial inflows of $ 20 billion. The trend should continue. Despite having a surplus of domestic savings, Beijing has opened its financial markets to unimpeded foreign inflows in recent years. The main purpose of this is to gain international prestige for these markets and to promote the worldwide use of the renminbi.
But this prestige has its price. As long as it refuses to reintroduce capital controls – which would undermine many years of gradual opening – Beijing can only adjust to these inflows in three ways. Each has its own cost, which increases with increasing foreign inflows.
One possibility is to allow the renminbi to rise in value as foreign demand increases. The problem, of course, is that this would undermine China’s export sector and encourage further inflows, which in turn would drive China’s huge trade surplus into deficit. In this case, China would have to reduce the total amount of its production (and thus reduce gross domestic product growth).
The second possibility is for China to intervene to stabilize the value of the renminbi. For the past four years, China’s currency intervention has not taken place directly through the People’s Bank of China, but indirectly through the state banks. They have amassed more than $ 1 trillion in net international assets, mostly in the past two years.
Large currency interventions, however, are incompatible with domestic currency control because China needs to create the renminbi it uses to buy foreign currency. The consequence, as the PBoC has warned several times this year, would be too rapid an expansion in domestic credit and a worsening of domestic asset bubbles.
Many readers will realize that these are just versions of the central bank trilemma: if China wants open capital markets, it must either give up control of the currency or the domestic money supply. However, there is a third way Beijing can respond to these inflows and that is by encouraging the Chinese to invest more overseas so that net inflows are reduced by higher outflows.
And that is exactly what regulators have tried to do. Since October last year, they have implemented a number of measures to encourage Chinese people to invest more overseas, not just institutional investors and corporations, but households as well.
But even if this policy were successful (and has not been successful), it would bring its own risks. In this case, overseas institutional investors pouring hot money into liquid Chinese securities will be offset by various Chinese companies investing in a variety of assets overseas for a number of purposes.
This would give China a classic developing country problem: a mismatched international balance sheet. This increases the risk that foreign investors in China could suddenly exit at a time when Chinese investors are unwilling or unable to repatriate their foreign investments quickly enough. We have seen this many times: a rickety financial system held together by the moral risk of government support has to cope with an increase in hot money inflows, but cannot adjust quickly enough when they turn into outflows.
As long as Beijing wants to maintain open capital markets, it can only react to inflows with a combination of the three: a disruptive appreciation of the currency, a too rapid increase in the domestic money and credit supply or a risky international balance sheet. There are no other options.
Therefore, the current stock market turmoil can be a hidden blessing. As foreign investors become more cautious with Chinese securities, it will reduce the inflow of foreign hot money, reducing the pressure on tax authorities to choose between these three bad options.
Until it radically cleans up and reshapes its financial system, in other words, China’s regulators should be more concerned about too many overseas purchases of its stocks and bonds than too little.