For much of the summer, troubling economic news from China seemed to wind its way west. Asian markets would plunge, European markets would falter, and Wall Street would swoon.
While China’s emergence as an economic power has been remarkable, it is not the world’s biggest economy, nor are its stock markets the world’s largest or most significant. Furthermore, most of the debate among economists is over whether the Chinese economy is growing around 7% – the government target – or a more modest 5%; neither would really denote disaster.
So why such a strong reaction?
First and foremost, China’s tumultuous summer calls into question its economic trajectory. China was the rare flame of growth in the post-crisis global economy and that flame is now flickering. In the wake of the market tumble of 2008, emerging market economies grew substantially faster than developed economies. Not only was China the largest and best-performing of the emerging market economies, but its ravenous demand for commodities helped lift countries like Brazil, which now finds itself in recession. While direct trade and financial linkages with China may be too limited for a shock to drag the United States under, it will be hard for the United States to flourish alone in a faltering global economy.
Second, the Chinese government’s role in the summer flailing has undercut confidence in its economic management. The Shanghai Stock Exchange hit its peak on June 12 and proceeded to fall almost 40%. That would have been worrisome enough, but the fall was punctuated by bouts of government intervention. Chinese officials reportedly spent over $200 billion propping up the stock market. This was coupled with a campaign to question the actions of market skeptics, from short-sellers to journalists. Such an approach not only confounded investors in the short-run, but could also limit the extent to which Chinese exchanges can convey important information about the state of an economy and the proper allocation of capital.
China’s handling of its currency was no more reassuring. On August 11, the RMB fell against the U.. dollar. This seemed to mark a sharp shift in Chinese policy, which had previously guided the RMB on a slow and steady upward path. Was China devaluing to give its troubled exporters a price advantage? Was China now yielding to global currency markets and allowing them to set its exchange rate? A month later, it’s still hard to tell. The government has devoted almost $100 billion in foreign exchange reserves to keep the currency from falling further. As a result, the currency is only about 2.5% weaker than before China’s move – hardly enough to reorder trade flows.
The downside is that, for both currency and the stock index, the Chinese government now seems to “own” the price – it will bear responsibility for future ups and downs, given its heavy involvement. The Chinese government seems to have gained little in exchange for assuming this liability.
The third channel through which China’s summer travails could drive down global equity indices is the more universal lesson that bubbly markets can and do pop. The Shanghai Stock Exchange, before its vertiginous drop, had more than doubled from the end of summer 2014. Upon observing its fall, investors around the world can then ask whether their own domestic stock markets look overpriced and vulnerable. For the United States, at least, Nobel Laureate Robert Shiller answered “yes.”
The final avenue of concern comes from the potential response of other countries to China’s actions. In the wake of China’s August depreciation, the phrase “competitive devaluation” sprang to the lips of many analysts and critics. The worry is that a country with slowing domestic demand will push down its currency so as to make its goods and services look cheap relative to those of its competitors, thereby ‘swiping’ some scarce demand. Although China’s actions to date appear unlikely to do this, the signal was enough to stir concern.
This past weekend, the Group of 20 (G20) finance ministers tried to reassure worried global markets. The Chinese economy was nothing to worry about.
They declared: “We will refrain from competitive devaluations, and resist all forms of protectionism.”
Unfortunately, in recent years, the G20 has been better at flagging global problems than it has been in deterring or resolving them. The strong market reactions to developments in China are likely to persist.
Philip I. Levy is a senior fellow on the global economy at the Chicago Council on Global Affairs. He is also adjunct professor of strategy at the Kellogg School of Management at Northwestern University.
