China’s economic policymakers have to learn to let go if they want to establish credibility
Yasheng Huang says officials have acted with exuberant irrationality in their desire to retain control, revealing a troubling lack of understanding about the realities of market economies
The ability of the Chinese government to control is undisputed and unparalleled compared with governments in other countries and, indeed, compared with the Chinese state during imperial times. If the stock market does not go up, then prevent it from going down by shutting it down. If too many investors want to cash out their positions at the same time, just charge them with “malicious intent to sell” and arrest them as proverbial chickens to scare off the monkeys.
The problem is that a government so focused on and obsessed with controls is not one that cares about or is particularly good at establishing credibility. A government needs credibility when it tries to convince others to do its bidding without the ability to dictate actions directly.
In his book, The Courage to Act, Ben Bernanke wrote about how US Federal Reserve officials debated and deliberated long and hard about particular words and phrases, and even about the usage of different punctuation marks, in their communiqués with the public.
The reason is that the effectiveness of the Fed does not depend on its ability to arrest people at will but on how it is perceived by market participants – whether it is perceived as being capable, deliberative and above all credible. If the Fed lost the confidence of the market, much of its influence and leverage would evaporate.
The most worrying sign out of China is not that its GDP growth has slowed to 6.9 per cent. The most worrying sign is that Chinese economic policymaking seems to be completely divorced from the realities of a market economy. In a market economy, policymakers need to think about credibility and should only choose to do those things that have a reasonable chance of success. They should also take into account not just their actions but also reactions to their actions.
By these criteria, economic policymakers in China have fallen far short. Many focus on the stock market turmoil last August and earlier this year but, to me, the most troubling illustration is the market bull run that began in the autumn of 2014. By June 2015, the Shanghai Composite Index had more than doubled within a year. The puzzle is not why the stock markets in China have crashed but why they rose so far and so fast in the first place.
All the evidence shows that the stock market bull run was deliberately engineered by the government. Editorials in People’s Daily talked up the market and the regulatory authorities tacitly permitted the dangerous practice of margin trading. This is remarkable. All of this happened at a time when China’s GDP slowed noticeably; its overcapacity worsened, and Europe, an important trading partner, was mired in a recession. The fundamentals for this market surge are only notable in their absence.
This is not irrational exuberance; it is exuberant irrationality. It is amazing that a government in charge of the second-largest economy in the world apparently failed to anticipate that a market so burdened with negative fundamentals would have to come down.
Another illustration is the failure to anticipate the obvious psychological contagion of the sudden devaluation of the renminbi last August 11 that sent shock waves around the globe.
The devaluation happened amid extraordinary market fragility and it is a mystery why the policymakers timed the decision so inopportunely and so poorly. The only explanation is that the Chinese policymakers, who are so used to simply dictating actions to their subordinates, had very little inkling of how market psychology operates. Investors and analysts would not assess the preceding individual events during the summer – stock market crash, desperate market rescue and export declines – separately but cumulatively.
The surprise devaluation simply reinforced and amplified the gathering consensus about the jarring weaknesses of the Chinese economy. History will show that the sudden devaluation decision was the signature straw that broke the camel’s back.
It does not appear that Chinese policymakers have learned useful lessons from all these mistakes. The new year opened with new rules designed to reduce market volatility – the circuit breakers that would automatically suspend trading once price declines crossed a certain threshold. But there are two problems.
One is, again, inauspicious timing. More sophisticated policymakers would have thought hard about the timing of introducing the rules and would have chosen a time when the market jitters had settled down. Introducing circuit breakers when investors are still nervous is equivalent to announcing through a loudspeaker that you think the market is deeply troubled. Investors acted on cue and exited en masse. Introducing the circuit breakers reinforced rather than alleviated existing psychological fragility.
Another problem is that the threshold was set too low, at 5 per cent, which all but guaranteed that it would be easily triggered. This is not merely a technical mistake; it is symptomatic of a profound desire to control. What may appear to policymakers in other countries as normal market fluctuations are viewed as chaos and turbulence by the Chinese, and they are determined to stamp them out completely. The result, as we know now, is nothing short of a disaster.
For good or bad, a hallmark of a market economy is its fluctuations. A mature and capable government learns to live with, and devises ways to manage, these fluctuations. As is well known, China needs to fundamentally change its way of economic growth, from investment- to consumption-driven and from brute forces of capital accumulation to technology and innovation. But an equally important task is to change the mindset that one has to control every minutia of change and circumstance in economy and society, and to focus on establishing policy and governing credibility.
Yasheng Huang is a professor at MIT’s Sloan School of Management, where he founded and heads the China Lab and India Lab that provide low-cost consulting services to SMEs in China and India. He is co-author of MIT’s Innovations and Innovating Innovations (both in Chinese)