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In Conversation with Xiao Geng: On Market Volatility

In Conversation with Xiao Geng: On Market Volatility

Posted on Friday, August 28, 2015

Professor Xiao Geng discusses the underlying causes of China's market volatility.

Q: The recent volatility that has overtaken China’s market came on after we saw some very dramatic gains and losses. What brought this about?

First of all, China’s market volatility has helped us identify two types of investors in the market.

The first type of investor represents those who are optimistic about the future and have bought into the reform dividend – the policy dividend, if you will; the sentiment that drives them has become known as the “reform bull.” That factor has created a kind of “irrational exuberance” with Chinese characteristics.

Optimists focus on the reforms undertaken by the Chinese President Xi Jinping, which were first announced during the Third Plenum in 2013 when China’s leaders endorsed a decisive role for market forces in the economy. Following on from this and at the Fourth Plenum in 2014, President Xi stressed the importance of the Rule of Law. In March 2015 at the Boao Forum, President Xi announced the “One Belt, One Road” initiative to build better connectivity among China and its neighbors and trading partners for more effective and sustainable growth. On top of all these medium- and long-term initiatives and policy changes, we have seen a push for reforms within China’s financial markets, as well as developments involving the RMB internationalization and the promise of inclusion of RMB into the International Monetary Fund’s (IMF) Special Drawing Rights (SDR) basket of currencies. All of these are wonderful and ambitious policies, but these can only create benefits and returns in the medium and long term.

At the same time, there are those who have been pessimistic about their economy, and these make up the second group of investors. Their sentiments are backed by statistics, especially by the numbers that we saw in August, with 43 consecutive months of decline in the PPI (Producer Price Index) and about 8 per cent drop of imports and exports in July. These are just the latest indications that China’s economy has been in a downward adjustment over last four years.

In the short-term, China’s statistics show that the economy, particularly the real economy is not doing very well. While the market increased in value by about 150 per cent at the peak in June over the last 12 months, it then retreated 30 per cent in July. After the fall in last few days, the index lost all of the gains in 2015. So on the whole, a lot of paper wealth was created and then destroyed, creating high volatility and uncertainty over market liquidity, production, and consumption. While China’s GDP continues to be helped by the cost of labor, capital and pollution control, market volatility and uncertainty are taking its toll on the confidence of business and consumers and generating deflation expectations.

Q:  What in the market made the bears overcome the bullish sentiment that took hold earlier this year?

I would say the market turnaround is the result of the interaction between and among four cycles:

  1. The first cycle is monetary; the PBOC has been tightening monetary policy since 2012, largely because the 2008 stimulus created excessive infrastructure expansion, particularly at the local government level in the 3rd and 4th tier cities. That, in turn, has created problems which the PBOC have tried to address by tightening credit. That cycle began in 2012 and the tightening ended last October. That tightening, has resulted in a sharp slowdown in the growth of credit and is an important part of the underlying cause for the current deflation cycle.
  1. The second cycle is structural. Because authorities are trying to deal with local debt and shadow banking problems, there has been consistent tightening of fiscal revenues at the local government level. The anti-corruption drive has also had the effect of an overall tightening in physical expenditures. As a result, all levels of China’s government are currently sitting on vast sums of cash, which cannot be spent timely and efficiently. This cycle is far from over, because we still need to see non-productive local investments go bankrupt so newer and more productive projects can be undertaken.
  1. The third cycle involves reforms and politics including major medium- and long-term reforms started over the last three years. These reforms include accountability, discipline, and anti-corruption as well as deregulation and market liberalization. These reforms are crucial to creating medium- and long-term dividends that will have a positive effect on the country as a whole. But in the short-term these measures are contractionary because they are effectively austerity programs creating uncertainly.
  1. The fourth cycle involves a global slowdown; this includes the problems we see in Greece; a slow recovery in Europe and Japan; and a steady, albeit slow move towards stabilization in the United States.

These four cycles are dragging down real economic activity in China, and they are generating deflationary measures, not just in China but around the world.

Given the negative impact of these four cycles, I am not surprised to see the heightened state of stock market volatility in China and around the world.

Q: What then would you consider to be the underlying cause of market volatility in China today?

The current volatility is actually a stress test in the sense that the Chinese government is allowing the market to express its views through both the stock and exchange markets. Of course we can link part of the volatility to the volume of unregulated margin investments and timing of the exchange rate reform, but the underlying forces generated by the four cycles would still lead to a sharp correction of the market, perhaps in a less dramatic manner.

But over the longer term and after the correction of the overly tight monetary and fiscal policies, I do expect that China’s growth rates are likely to return to normal.


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