China’s economy: The key flaw that’s shaking markets

Editor’s Note: Timothy Fuerst is William and Dorothy O’Neill Professor of Economics at the University of Notre Dame. Fuerst’s research has been published in the American Economic Review, Journal of Monetary Economics, Journal of Economic Theory, and many other journals. The opinions expressed in this commentary are his.

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Timothy Fuerst: Global market gyrations can be traced back to China

He says China's heavily state-owned financial sector isn't suited to handling its enormous economy

CNN  — 

The astonishing stock market gyrations over the last few days are closely linked to economic news coming out of China.

Timothy Fuerst

The importance of China for the global economy cannot be over-stated. First there is sheer size. China is the second largest economy in the world and a significant importer of commodities such as copper and oil.

Second, the world has come to expect Chinese economic growth rates of 10-12%, growth rates that have helped bolster the world economy especially during turbulent times in Europe and the U.S. But now Chinese growth is slowing, and there are significant concerns about the health of the Chinese financial system.

Most observers had anticipated a steady decline in economic growth as China emerged as one of the world economy’s leaders But the doubts about the Chinese financial system are particularly troubling.

In many ways China has followed the typical pattern of economic development.

From farming to services

At low levels of development, a nation’s employment and production are primarily agricultural. As a nation becomes richer, production and employment slowly shift from agriculture into manufacturing and services.

The United States is a typical example of this pattern as the nation evolved from agriculture in the first 100 years after independence into a manufacturing behemoth in the late 19th and 20th century to the sophisticated provider of services that now dominate U.S. employment and production.

What is unique about China’s economic history is the rapid movement through this development ladder. This development took place over more than a century in the U.S., but is now taking place in China in about half the time. This rapid growth is surely good news for Chinese citizens and for the rest of the world. The historic pattern is that these growth rates slow as a nation’s standard of living begins to approach those of the leaders. It is in this sense that the Chinese growth slowdown is anticipated.

But what has roiled worldwide markets are growing doubts about the health of the Chinese financial system.

The problem with China’s banks

Hand in hand with a nation’s economic development comes the need for increasing sophistication in the financial sector, as the borrowing and lending needs of an agrarian economy are quite different than those of a manufacturing or service-based economy.

In fact, one historic source of crises is financial sectors that have not kept pace with the needs of the underlying economy. This was one of the deeper forces underlying the U.S. experience during the Great Depression.

It now appears that the Chinese financial system has not developed as quickly as needed. The system continues to be dominated by state-controlled banks who funnel lending to large state-owned enterprises. And these SOEs are large: The top 12 Chinese companies are state-owned.

In a market-based financial system, these SOEs would decline in size over time as lending would flow to the more productive private firms and small-scale entrepreneurs. But this type of reallocation is not happening in China, thus leading to serious concerns about the long run health of the Chinese economy. The effect on Chinese stock markets is direct. If most funding flows towards unproductive SOEs at the expense of more vibrant private firms, stock market returns will suffer (the Shanghai index is off nearly 40% since June).

What does this mean for the U.S.? The stumbling of such a large trading partner will have knock-on effects throughout Asia, and lead to a modest dampening of U.S. export activity. But more importantly, the Chinese stumbling will have significant effects on commodity prices such as oil and copper.

Although price movements are an important coordination mechanism in market economies, large and unanticipated movements in these prices can be destabilizing, especially for nations and companies that are large players in commodity markets.

The rush out of stocks and into the safe haven of U.S. Treasuries raises more concerns as many have argued that these markets are less liquid because of new regulations imposed since the 2008 financial crisis. The problem with illiquid markets is that they often imply over-reaction of prices and yields.

It isn’t 2008 all over again

What does this mean for U.S. policymakers? The Obama administration should continue to press China for reforms in the Chinese financial so that it can catch up with the rest of the nation’s development. For example, the administration should encourage the Chinese government to slowly divest itself from the financial sector (currently the five largest Chinese banks are majority-owned by the central government).

The Federal Reserve should stand ready to provide liquidity to financial markets to facilitate these large movements out of equities and into the bond market. This liquidity provision would be a small-scale version of the Fed’s lending programs in the wake of the 2008 financial crisis. The current environment is quite different than 2008 as today US banks have limited exposure to Chinese equity markets.

All of this must be something of a nightmare for the Fed. There seemed to be a growing consensus to raise short term interest rates in their September meeting for the first time since 2006, but there is now one more reason to postpone any tightening.

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