Tuesday, July 28, 2015

China's Financial Isolation

China's manufacturing sector is deeply embedded in the world economy, and has made China an economic superpower.  But China's government has isolated the Chinese financial system, and that turns out to be a good thing for the rest of the world.

China's stock market has fallen about 30% from its recent high in June 2015.  The impact on investors of this dizzying drop has been acutely painful, especially for recent entrants.  Many of those purchased on margin, and have taken crushing losses.  The Chinese government has announced various measures to pump more money into the stock market and stabilize prices.  The verdict on this blatant governmental effort to manipulate prices has yet to come in. 

However, the rest of the world hasn't felt much impact from the gyration's of China's stock market.  While foreign investors in Chinese stocks have taken losses, it's not that easy for foreigners to invest in Chinese securities.  Similarly, it's difficult for foreign banks to do business in China.  They wouldn't have that much at stake, since the Chinese government limits the scope of their activities.  Although foreign losses in China aren't trivial, they also aren't enough to destabilize the international financial system.

The Chinese government deliberately limited foreign access to the Chinese financial system, fearing the volatility seen in the 1997 Asian financial crisis, when Western capital exited, stage right, as things got stinky.  This rapid outflow of capital only made things worse for the developing Asian nations.  The last thing the Chinese government wanted to do was indenture itself to Western capital.

Of course, what the Chinese government did on its own was pretty silly.  It tried to use monetary and regulatory policy to stimulate the economy by pumping up stock prices.  This is unpleasantly reminiscent of U.S. government policy in the early 2000's to stimulate the economy by pumping up real estate prices.  The Chinese have greatly modernized their nation in the last 40 years by adopting ideas from the West, but imitation can be taken too far. 

Financial websites are filled with speculation about the supposedly dire consequences to everything in the entire world from the drop in Chinese stocks.  Not to be a cynic, but bad news is news and good news is trash left at the copy desk.  The most likely impact from the turbulence in the Chinese financial markets is an economic slowdown within China, and a possible economic slowdown in the rest of the world.  But the Chinese financial system won't collapse.  That's because the Chinese government, which owns and/or controls China's banks, can simply print money to recapitalize them.  Since the Chinese government controls trillions of dollars of foreign exchange, it can make sure that foreign banks having exposure to Chinese financial institutions aren't left in the lurch.  The Chinese can't let their stock market gyrations take down the rest of the world's financial system, or they won't have any export markets.  And if the Chinese economy slows, they'll seek to export their way back to prosperity.

Of course, stay vigilant.  The economic slowdown in China is one of the major factors pushing down commodities prices.  It's possible that secondary and tertiary effects of the drop in commodities (and the currencies of commodities producing nations) could have unanticipated impact on Western financial institutions.  (Don't underestimate the potential for major banks to have unexpected exposures from derivatives positions and overly optimistic lending policies.)  But, thus far, China's financial isolation has largely protected the rest of the world from China's financial mistakes.

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