A few months ago, the Chinese financial sector experienced numerous setbacks as it experienced unprecedented depreciation of its currency and a tumbling stock market.

The Shanghai Composite Index, China’s main benchmark, closed 6.4% down at 2,749.79 on Jan 26 and the plunge does not seem to be stopping.That was the index’s largest one-day percentage loss since the Chinese government got rid of a “circuit breaker” mechanism on Jan. 8. The system, put into place at the beginning of the year, was blamed for sparking rather than stopping volatile trading.

Weakness in the Chinese Economy

The major fall in China’s index can be attributed fundamentally to its weakening economy. After more than 30 years of rapid economic growth, labour wages are rising. Investment rate-of-returns are rapidly falling. China’s voracious demand for commodities is slowing down as seen from the crash of nearly all commodities prices. Moreover, during the boom years, over-investment was seen in major core industries such as steel, construction and property. Although such investment pay not have an effect in supply over a short-run, over the long-run as we are experiencing right now it will generate spare capacity, further placing downward pressure on prices. This has jump started the massive selling of China’s stocks as economic growth has revised downwards.

Besides its weakening economy, the increase in interest rates in the US has sparked massive capital flight from China. Although China sets up capital controls, leakages still occur within the system resulting in hot money to flow from China to the US. Outflows jumped in December, with the estimated 2015 total reaching a record $1 trillion, more than seven times higher than the whole of 2014 based on Bloomberg Intelligence data dating back to 2006. Such leakages have resulted in an increase in the supply of Yuan in the global market which places downward pressures on the Yuan.

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From its historical low of 1 USD to 6.20 RMB, the RMB has depreciated to its current level of 1 USD to 6.5777.  The PBOC(central bank of China) has made major effort to defend the Yuan to ensure currency stability. It has used its hoard of foreign reserves to buy up Yuan, increasing demand and reducing supply to prevent further depreciation. It is doing so for 3 major reasons:

  1. Capital flight results in a reduction in loanable in banks. This has a contractionary effect on the economy as the decreased supply of funds puts upward pressures on interest rates and increases the cost of borrowing. This reduces investment and consumption, reducing AD while the economy is already experiencing a structural slowdown.
  2. In Nov 2015, the IMF has decided to add the Yuan into its special drawing rights currency basket. The development is key to ensuring that the Yuan becomes internationalized, expanding its financial sector and breaking the monopoly currently held by the USD. But to do so, the Chinese government needs to maintain confidence on the Yuan and needs to show discipline in ensuring a stable exchange rate. A rapidly depreciating Yuan is not what foreign investors will like to see as a possible future global currency as it affects their expected rate-of-return.
  3. A depreciating currency reduces the value of assets in terms of foreign currency. Thus, a depreciating currency may spark further capital flight as investors shift their money out to maximize returns. It turns into a vicious cycle where capital flight triggers a depreciating currency that further encourages more hot money to escape. Although the PBOC currently has a large amount of foreign reserves at its disposal, it needs to ensure it stop gaps the panic flight before its reserves amount gets threatened.

With the $107.9 billion drop in December, Beijing’s foreign-exchange reserves have fallen every month but one since May. Tough times loom ahead for the Chinese economy as the US may potentially further raised its interest rates later in the year which may sparked further capital flight.

The road ahead

The truth is that China’s golden opportunity to reform its financial sector may have disappeared. Previously, cheap credit from around the world flowed to developing countries thus funding their development and investment. Exchange rates were relatively stable as seen from the gradual and modest appreciation of the Chinese Yuan. A stable exchange rate and ample capital made it favorable for financial reforms to take place since markets were stable and massive capital flight was unlikely.

However, much has changed. Global economic growth has decreased. China’s economy faces dire spare capacity in its key industries. Most importantly, the Federal Reserve has ended QE, raised the short-term interest rates in December 2015 and probably intends to further normalize interest rates in the days ahead. This has exasperated capital flight from developing countries, especially China.

Just as China attempts to open up its financial sector and relaxes capital controls, the global conditions will only encourage further capital flight and put further threat on its economic stability as it faces a depreciating exchange rate and a sluggish economy.

Contrary to popular belief, the better short-term solution is perhaps to increased capital controls to stabilize the Yuan and prevent further capital flight. When the market stabilizes after the series of rounds of interest rates rise by the Federal Reserve, China can then make use of the opportunity to gradually open up its financial sectors in selected areas such as Shanghai and Beijing.

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