August 2015
Schroders
Talking Point
Storm clouds lift in China
Keith Wade, Chief Economist
Recent events are a reminder of how the Chinese market still relies on policymakers to step in and
keep the show on the road. The can has been kicked down the road, but the underlying problems
remain.
Storm clouds have lifted a little as the Chinese authorities act to stabilise the A-share index. The situation is
fluid but there are some signs of stabilization. Reports suggest that the banks have provided some $200 billion
of funding to prop up the market via the China Securities Finance corporation.
Figures on the amount of bad debt created by the fall in the stock market can only be guessed at. Even after
recent falls the Shanghai composite is still up 15% year to date as at the end of July, according to Bloomberg,
indicating that investors could still be sitting on substantial profits. Unfortunately it is more likely that many are
now mired in margin debt as they leveraged into the bubble. Consequently, alongside measures to suspend
trading in a number of stocks and police investigations into “malicious” short selling, the scale of the bank
injection indicates the depth of official concern over the stability of the financial system.
It is a lack of visibility on the scale of bad debt in China’s banking system that is creating caution amongst
investors who continue to avoid emerging markets. We would see this as the last leg of the wider global
financial crisis which has seen banking systems go through crisis, government rescue and recapitalisation in
the US and Europe. China still needs to purge bad debts and recapitalise its banking system, although the
process has begun through the bond swap programme and government-directed forbearance.
Meanwhile, there will be fears of a hard landing in China as investors weigh the risk of a misstep by the
authorities. Recent official action by the authorities may have reduced the risk attached to this scenario, but the
underlying problems of overcapacity and misallocated resources in China remain.
Separately, the decision by the People’s Bank of China (PBoC) to alter the way in which it fixes the yuan – now
taking into account the previous day’s closing spot rate – is a significant one. But contrary to many media
headlines, we do not believe this is primarily a policy aimed at providing stimulus to exporters.
The resulting depreciation, less than 2%, means that in trade-weighted terms the yuan is back to the level it
was at the end of July. This is not the kind of change that will see a boom in Chinese exports. Far more
important is the increased role of the market in determining the value of the currency. Consequently, we see
this more as a reform aimed at Special Drawing Right (SDR) inclusion, rather than at boosting growth.
That said, the PBoC’s chief economist has said that the central bank will stabilise market expectations to
ensure an orderly transition to the new regime. This is not the end of intervention. Indeed, we think it would be
unwise to allow a large depreciation at this time, given the sizeable capital outflows recorded in the first half of
the year. Entrenching expectations of depreciation would serve only to exacerbate those outflows and
potentially destabilise the financial system.
Will we see much more depreciation from here? Beyond the risk of capital outflows, which should discourage
policy-led depreciation, there remain structural supports, particularly in the form of the current account surplus.
But the reference to the closing spot rate, in current market conditions, will exert some depreciation pressure.
PBoC intervention will be needed to alter market expectations if the authorities want to prevent depreciation.
SchrodersTalking Point
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One final change to note is that the fixing will also be determined by the exchange rate movements of major
currencies. That possibly implies a move away from a pure dollar peg to a basket of currencies. If this is so,
and the PBoC wants to peg the yuan in trade-weighted terms, depreciation versus the US dollar becomes
more likely, particularly if the wave of dollar strength continues. However, we believe financial and social
stability remain the overriding concerns of policymakers, and so a large devaluation is not on the horizon.
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