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Lessons from China's summer of instability

Lessons from China's summer of instability

Markets are drawing the wrong conclusions 

by John Nugée

Fri 4 Sep 2015

A common market axiom is: ‘Nothing ever happens in August’. In fact, this has often been proved wrong, from the start of the financial crisis in August 2007 all the way back to the outbreak of the first world war in 1914. And this year has provided yet another counter-example. The summer-long swooning of the Chinese stock market caused western nerves to crack and markets to dive in sympathy.

It is worth standing back to consider why this was so, and what is driving that weakness. Signs of a softening Chinese economy are not good news for international economic activity, and for world markets. China’s economy, after a generation of rapid growth, is now the second largest in the world, and represents the largest single contributor to world growth. The Chinese economy matters.

And for any other economy, it might be a fair assumption that extreme weakness in the stock market reflects weakness in the underlying economy. The falls on the Shanghai bourse are surely a warning for the West.

But the assumption that Chinese stock market falls tell us anything about the Chinese economy is far from well-founded. Put simply, the Chinese stock market is not a free market and contains much less information about the state of the underlying economy than almost any other major market. And westerners who assume otherwise are guilty of making one of the oldest mistakes in the book: assuming that China follows established norms and responds to standard analysis.

On the contrary, China challenges almost every established economic theory for the way in which countries and economies develop, mature and operate. We have to realise that the economy is simultaneously the world’s second largest, yet is also still a developing economy. Furthermore, it is under the close, direct control of the state, yet defies all the authorities’ attempts to manage it. In the most basic sense, we have never before seen another case where the government has all the levers and tools – yet they simply do not work as the authorities thought they did.

With regard to China’s currency, the same paradoxes apply. China is a great trading nation, but not an open economy, and its currency is widely used outside its borders without being convertible. Such an economy simply does not follow precedents set by other, smaller countries.

Those who lazily try to pigeonhole China (for example as an ‘emerging economy’ or ‘great trading nation’), and then assume that it will behave as the pigeonhole suggests, risk being repeatedly caught out. China is the epitome of sui generis, and demands original thinking to understand its unique challenges. Sadly, however, much of the world – both markets and the authorities – seems unwilling to think beyond the precedent, the orthodox or the mundane. And China is none of these three.

John Nugée is a Director of OMFIF.

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