Global markets were surprised by China’s devaluation of its currency, the renminbi, but they shouldn’t be. This is one of the inevitable outcomes of the bursting of its stockmarket bubble and Beijing’s lacklustre efforts to save the bubble as an engine of growth for a slacking economy. In the strategic calculus of Chinese policymakers, devaluation will stimulate exports, offsetting the drag caused by the collapse of equity markets.
A month ago, the Chinese government embarked on a mission that might have deterred even the fearless Don Quixote. Facing a crashing stockmarket, the Communist Party of China’s (CPC’s) top leadership decided to intervene on a massive scale and demonstrate its omnipotence. In short order, Beijing suspended all IPOs and ordered state-owned entities such as pension funds and insurance companies to purchase stocks. The central bank pledged generous liquidity support to brokerage firms, all of them state-owned as well, for their investments in the stockmarket. To warn “speculators with malicious intent”, a vice minister of public security showed up at the China Securities Regulatory Commission, the top securities regulator, investigating allegations of nefarious activities by unnamed individuals and entities.
For some time, it seemed that the CPC’s market-defying tactics might work. Panic selling subsided. After the government pumped in 1.2 trillion yuan (nearly $200 billion before the devaluation) into the market rescue operation, the Shanghai Composite Index surged 15 per cent within a week. Unfortunately, before officials could celebrate, sell-offs resumed. On July 27, the Shanghai Composite dropped 8.5 per cent, its worst plunge since 2007. In early August, exactly a month after Beijing started its intervention, the index languished at around 3,900, only 10 per cent higher than when Beijing started its market rescue, but still 20 per cent below its high in early June.
In hindsight, Beijing’s intervention had poor odds of success. Crucially, Chinese policymakers committed two elementary but costly mistakes in trying to save the stockmarket bubble. The first is haste. It intervened too early and bought into a bubble that needed to deflate further. When government-sponsored stock purchases began in early July, valuations (if you trust the financial statements by Chinese companies at all) were still excessively high. Blue-chip companies were trading at a price-to-earnings ratio of 22-25 and mid-sized and small companies commanded prices 40-50 times their profits. A large number of the same Chinese state-owned firms are traded at only 11-12 times their earnings on the Hong Kong stock exchange. It’s clear that in a moment of panic, Beijing bought overvalued stocks that would be expensive to support.
The second mistake Beijing made was in not thinking through its exit strategy. To be sure, governments in other countries have intervened in the stockmarket before. Those who have done a better job than others tend to have greater patience and a less disruptive exit strategy. Apparently, this is not the case with Beijing. After it quickly burned through 1.2 tn yuan in July, the Chinese government was apparently seized by buyer’s remorse. State-controlled entities not only slowed down their purchases, but also began to sell some of their holdings. It is not clear what Chinese officials were thinking. If they assumed Chinese retail investors could be fooled, they were clearly mistaken. Having been burned badly by the crash in June and early July, vigilant retail investors reacted instantly when they sensed the slightest flagging in the government’s efforts. Predictably, Beijing’s premature attempt to exit triggered the latest round of selling.
Arguably, the Chinese government finds itself in a worse spot than at the beginning of the crash. Having made the mistake of deciding to save a classic bubble when there were no real economic justifications, Beijing compounded the error with both ill-timed intervention and an attempted premature exit. Today, it is stuck with a task similar to that which god assigned to Sisyphus: a futile attempt to accomplish the impossible.
Besides losing face and wasting Chinese taxpayers’ money, the government has paid dearly for its misplaced faith in the power of the state. It is unclear whether Chinese leaders realise this, but their expensive attempt to support a bubble has been a huge distraction from their real top priority — implementing difficult structural reforms to sustain Chinese economic growth. Instead of investing their time and energy in financial de-leveraging, squeezing out excess manufacturing capacity and reorienting the economy away from investment to consumption, Chinese leaders now find themselves helplessly watching the erratic gyrations of stock prices. Needless to say, the 1.2 tn yuan they have poured into the market could have been far more productively spent on shoring up China’s banking system and restructuring heavy industrial sectors plagued with overcapacity.
Chinese leaders, particularly President Xi Jinping, will likely suffer a serious erosion of their carefully cultivated image of decisiveness and competence. In a one-party state without elections or meaningful opinion surveys, the closest proxy of public support for the government is the stockmarket index. When the bubble was taking Chinese stocks to new highs a few months ago, Chinese officials portrayed it as evidence of public confidence in Xi’s reforms. Now that stock prices keep diving, the same logic must imply that the public is losing confidence. An even more likely casualty is Xi’s economic reform plan. The crash is his first and most public setback. Opponents of financial liberalisation, which has accelerated in the last two years, will almost certainly cite the turmoil in the stockmarket as reason to postpone or scrap new reforms, such as further decontrol of interest rates and capital flows. Internationally, the credibility of Xi’s reform plan has also come under question. International investors find it impossible to reconcile Beijing’s pledge to pursue bold market-oriented reforms with the contempt for market forces revealed by the government’s intervention.
While the scale, timing and haste of Beijing’s operation may shock many, it does not come as a surprise to sceptics who have always doubted the CPC’s commitment to reforms. They have watched this bad movie many times before. Every time the party has to choose between wielding the power of the state or relying on market forces, it has consistently opted for the former. In this light, China’s decision to devalue its currency should not come as a surprise at all. As strong believers in the power of the state, Chinese leaders firmly believe they can fight the invisible hand. All it takes is strong political will. We can only hope that they will be proven wrong this time.
The writer is professor of government and non-resident senior fellow at the German Marshall Fund of the US