China: a classic case of overreaction?

China cuts interest rates to stabilise its volatile economy, leading some to call for a return to QE in the west.

by Adam Gale
Last Updated: 08 Jan 2016

There’s nothing like a little volatility to give people the jitters, and China’s principle stock market is currently about as stable as a pint of nitro-glycerine in a paint mixer. The Shanghai Composite Index closed down 1.3% today, up from a low of -3.9% - and a high of +4.3%.

This follows two disastrous days when the markets fell 8.5% and then a further 7.5% (‘Black Monday’ and, presumably, ‘Charcoal Grey Tuesday’). The likely reasons that today’s eventual fall wasn’t in the same league are China’s reduction of the interest rate from 4.85% to 4.6% and its injection of approximately $100bn (£64bn) of liquidity by relaxing bank reserve requirements.   

Just how calming these stimuli have been remains to be seen over the next week or two. Markets in the West responded broadly well so far, with gains in Europe and modest losses in the US.

Unfortunately, China’s recent, drastic actions (beginning with removing the dollar peg and letting the yuan slide a couple of weeks ago) have also inadvertently advertised quite how worried the country’s leaders are about their economy.

Fearing that a stalling Chinese engine could drag the rest of the world with it, some people are starting to call for the West to backtrack on its plans to raise interest rates, and instead return to the good old days of quantitative easing.

These aren’t just some guys down the pub, either. Notable among them are eminent economist and former US Treasury Secretary Larry Summers and hedge fund supremo Ray Dalio.  

That might be enough to give doomsayers a warm tingly feeling, but let’s not get carried away. Summers said the outlook for China was ‘clouded at best’, and was more concerned with market volatility than some imminent Asian depression, while Dalio merely thought we ‘could be in the very early stages of a very serious situation’.

On the other hand, there are voices like Goldman Sachs, no less, which said that the commodity price collapse isn’t so much a symptom of Chinese industry grinding to a halt, but rather a ‘benign’ consequence of oversupply. 

Of course, no one actually knows, a problem made worse by China’s less than ideal levels of transparency. It could be worse than we think, or indeed better, with current GDP growth figures ranging from around 3% to the official 7%.

The problem with uncertainty, though, is that it too causes major problems. Who wants to invest or buy an expensive holiday when a major recession might be round the corner? It’s uncertainty as much as anything else that’s causing markets worldwide to wobble.  

What’s fairly clear is that China has been trying to move away from an investment-led economy to a western-style consumption-led one. That transition was always likely to be painful, with ‘wasted’ investments causing losses and the decline in ancilliary markets (such as construction and machine tools) hitting aggregate demand.

The Chinese authorities are trying to smooth the transition (a change that isn’t entirely of their own making) with monetary stimulus, but it could be too little too late. More rigorous standards for scrutiny of official figures certainly couldn’t hurt. Given the Communist Party's rather firm grip on sources of information (here's looking at you, army of Chinese censors), we probably shouldn't hold our breath on that one.


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