CHINA´S POLICY FAILINGS CHALLENGE THE FED / THE FINANCIAL TIMES COMMENT & ANALYSIS

China’s policy failings challenge the Fed

Gavyn Davies

President Xi Jinping (L) with Chinese Premier Li Keqiang  © Getty Images

It would be easy to dismiss the recent extreme turbulence in global financial markets as a dramatic, but ultimately unimportant, manifestation of illiquid markets in the dog days of summer. But it would be complacent to do so. There is something much more important going on, involving doubts about the competence and credibility of Chinese economic policy and the appropriateness of the US Federal Reserve’s monetary strategy. These doubts will need to be resolved before markets will fully stabilise once more.
 

The August turbulence was triggered initially by a renewed collapse in commodity prices. For the most part, this was due to excessive supply in key energy and metals markets, and the sell-off only became extreme when there were panic sales of inventories, and a final unwinding of “commodity carry” trades. This inverse bubble was a commodity market event, not a reflection of weak global economic activity. In fact, taken in isolation, it would probably have been beneficial for world growth, albeit with very uncertain time lags.

 

However, that reckoned without the China factor. Activity growth in China had rebounded slightly following the piecemeal policy easing in April, but the data available so far for August suggest that the growth rate has subsided again to about 6 per cent, roughly 1 per cent below target. Although this is very far from a hard landing, it undermined confidence.

 

Furthermore, while overall Chinese activity was not disastrous, the sectors of the economy that were most important for commodities — real estate, construction and manufacturing — were clearly weaker than the expanding services sectors. China pessimists therefore found enough reason to combine commodity price collapses with a weakening manufacturing sector in the country, and claimed that the “inevitable” Chinese hard landing was at hand.

 

They have claimed this on many occasions in the past, and have always been proved wrong. But, this time, fuel was added to the fire in the form of the maladroit handling of the equity market bubble and the currency devaluation by the Chinese authorities. Suddenly, whatever reputation economic policy makers in China still retained for skill and competence lay in tatters.

 

Martin Wolf and David Pilling have rightly suggested in the FT that China’s economic problems are deep seated, stemming from an unbalanced economy that is far too dependent on investment, and on inherent contradictions between the need to introduce market forces in the long term, and the need to retain state control to deflate the leverage bubble in the short term.

 

Perhaps the regime of President Xi Jinping and Premier Li Keqiang needed to be super-human to navigate all this. But the policy errors of mid 2015 suggested instead that they were split, indecisive and confused.

 

The latest policy interventions, designed to place a floor under a collapsing equity bubble, and to allow a gradual devaluation of an over-valued exchange rate, might both have worked if they had been pursued with clarity and determination. After all, China has more than enough resources to under-pin its equity market and to set its desired exchange rate path. But the policy announcements were opaque and were partially abandoned almost before they had begun.

 

China’s economic problems will be a long time in the solving, but in the near term a combination of four initiatives would calm market nerves:

• monetary policy needs to be unequivocally eased to reduce deflation fears; so far, it has only been eased enough to offset the tightening effect of capital outflows;

• the exchange rate needs to find a level that no longer needs support from foreign exchange intervention;

• fiscal policy needs to be relaxed to slow the decline in investment;

• a transfer of debt is needed from the local government sector and the banking sector into the central bank and the central government.

Amid internal political feuds, such a co-ordinated package seems a long way off.

The Xi administration may see these steps as a return to the failed policies of President Hu Jintao — with some justification. But its alternative of adherence to pro-market reforms, while necessary for a healthy economic environment in the long run, needs to be buttressed by decisive action now to stabilise the markets. Simply blaming Mr Li for alleged incompetence, or Mr Hu for a poisoned legacy, will not fix the problem.

Shorn of any reassurance from a credible economic framework in China, western investors have turned their attention to their ultimate security blanket, the Federal Reserve. But the Fed seemed to have embarked on a pre-determined course to raise US interest rates before year end.

Admittedly, it always described this as “data determined”, but it has frequently added that it “expects” lift-off before the end of 2015. This addiction to calendar-related forward guidance, even after it has supposedly been abandoned, has caused trouble. As Lawrence Summers argued this week:

A reasonable assessment of current conditions suggests that raising rates in the near future would be a serious error that would threaten all three of the Fed’s major objectives — price stability, full employment and financial stability.

The financial markets have for a while been acting as if they are experiencing an adverse monetary policy shock from the Fed. In the bond market, the real yield has been rising, while inflation expectations have been falling. In the equity market, a long period of flat performance has given way to a sudden collapse.

My colleagues at Fulcrum, led by Juan Antolin Diaz, have recently been estimating econometric models designed to distinguish between monetary policy, economic demand and economic supply shocks to US markets. Their verdict: the last couple of months have seen a monetary tightening shock, rather similar to the one that hit the world during the taper tantrum in 2013. (A paper will be released on this soon.)

For the whole of 2015, the markets have refused to believe that the Fed would raise interest rates as early, or as fast, as the Federal Open Market Committee has shown in its “dots” charts for future interest rates. One interpretation is that the markets have placed greater weight on the possibility that secular stagnation is taking hold than the Fed has done.

As commodity prices have collapsed and the mood on Chinese policy has darkened, the markets have increased their belief that a rise in US rates would be inappropriate this year. Yet, until Wednesday’s slight adjustment to official Fed policy by William Dudley, the Fed has shown little sign of wobble in its determination to announce lift-off soon. Hence the collision with market confidence this week.

Some investors are beginning to agree with Mr Summers that another dose of quantitative easing may be necessary, even though Mr Dudley says that “QE4″ is far from his agenda. Others think that markets will be stabilised if the Fed simply abandons its oft-stated expectation that rates will rise this year.

What seems clear is that the Fed’s carefully orchestrated path for tighter policy is no longer consistent with stable financial markets. Something will have to give.