China’s challenges in the year of the monkey

The run-up to China’s year of the monkey has hardly proved auspicious. How will policymakers handle the challenges ahead? Could this be a year in which China reins back on reform?

In the last few weeks, China’s policymakers have been confronted by local stock markets in free fall, huge capital outflows as the value of the renminbi (RMB) currency has plunged and global consternation about the continuing slowdown in the country’s growth rate.

Progress in China’s reform agenda is often a case of “two steps forward and one step back.” If last year saw two steps forward, will the Year of the Monkey see policymakers moving back a step as they try to tackle pressing financial-market, currency and economic challenges, without abandoning their long-term reform goals?

How Will Growth Hold Up?
The more sluggish growth environment looks set to continue and, indeed, deepen as China moves into its fifth year of transition away from an export-oriented economy driven by government investment and debt and towards steadier expansion more reliant on domestic consumption and services.

While the “old economy” of heavy and low-value-added manufacturing and industry continues to decelerate, the services sector—especially e-commerce and financial services—is continuing to strengthen (Display). This structural rebalancing suggests that the Year of the Monkey is unlikely to witness a cataclysmic growth slump.

As a result, we’re not expecting policymakers to face pressure to resort to the kind of “big bang”–type stimulus that might challenge its commitment to a more balanced growth model. Instead, we expect more “softly, softly” initiatives to support growth, such as reducing interest rates at a measured pace and slightly more fiscal stimulus.

Something’s Got to Give
In addition to managing the country’s growth trajectory, policymakers also face big challenges given greater RMB volatility as Beijing has moved away from the RMB’s peg to the US dollar (USD) and adopted a strategy of managing the RMB relative to a basket of the currencies of its trading partners. While this move has assuaged some of the pressures attendant upon the peg to a soaring USD, it’s driven a precipitous decline in the value of the RMB, which, in turn, has been resulting in huge capital outflows.

Beijing has spent vast amounts of its USD reserves trying to shore up the RMB. Since this approach hasn’t worked, Beijing needs to think again (see China Walks an FX Tightrope). We see growing impetus to impose temporary capital controls to try to stop hot money haemorrhaging out of the country for a while.

A policy shift towards controlling capital outflows would be motivated by efforts to cap speculative activity, but it would represent a step backwards in efforts to internationalize the RMB in the run-up to the currency’s inclusion in the reserve currency special drawing rights (SDR) basket from October 2016.

Getting the RMB included in the SDR basket has been a key policy priority for Beijing. It could lure global capital into RMB assets, driving foreign currency inflows of some US$3 trillion into China over the medium to long term.

Meanwhile, the extreme turbulence of Chinese stocks in mid-2015 and again in early 2016 seems likely to temper policymakers’ immediate appetite for supporting domestic equity markets in the hope that they mature into a key funding channel for the country’s corporations. Income earned from equity-market trading was an important support for the country’s services sector in 2015. In the Year of the Monkey, equity markets look more likely prove a drag on growth.

The Policy Guidance Imperative
Ever since China began to rebalance its economy and press ahead with financial liberalization, there’s been uncertainty about how well its policymakers would handle the transition process. The last 12 months have seen some notable missteps (including futile efforts to prop up the plunging stock market and the surprise devaluation of the RMB last summer)—with global financial markets proving particularly rattled when policy moves have been both sudden and unexpected.

This suggests that Beijing is likely to tread very carefully if it decides that some short-term retreats could help bolster the major reforms enacted over the last several decades.

Anthony Chan, Asian economist at AB

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