Why the market is overplaying China’s troubles

By James Dowey, Chief Economist and CIO at Neptune Investment Management

The current volatility in global markets has precisely the same cause as had the major bout of volatility last August. As the Chinese RMB is pegged to the US dollar, US monetary policy gets exported to China.

This means that a strong US economy and a weak Chinese economy give rise to a tug of war at the centre of the global financial system. However, I believe the market’s gloom and doom is over the top. This is because the policy solutions are simple, feasible and being executed by the US and Chinese authorities. They are threefold and work best in combination.

First, the Fed must tread cautiously, releasing hawkish communication only when capital flows out of China are relatively becalmed – this is exactly what the Fed did last September, when it decided against raising interest rates at that time. I believe it will do so again with respect to the next rate hike.

Second, China can use fiscal policy to adjust domestic demand conditions to a strong exchange rate – and this is what the Chinese government is judiciously doing.

Third, China can change its exchange rate policy, by allowing the RMB to depreciate against the US dollar in the face of US dollar strength, and – given the authorities’ reluctance to allow the RMB to float freely at this point – manage it against a basket of major currencies rather than the US dollar alone. Again, this is exactly what China is doing.

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