China 'could learn from Swedish lessons'

Market turmoil has driven home the nation's large and growing importance to the world's economy

The world is rapidly coming to terms with the importance of China's economic weight, partly due to the international impact of the country's recent financial market turmoil, says Robert Bergqvist, chief economist of SEB, the Nordic bank.

Despite having emerged from the turmoil, China still needs to resolve some inherent concerns over its financial markets, especially the risk of capital outflows under current exchange rate fluctuation trends, he says.

Bergqvist, who worked as head of analysis at Sweden's central bank from 1988 to 1997, experienced firsthand the Swedish financial crisis in the late 1980s and early 1990s, and the experience is now making him think about China's currency policies.

At the time, the Swedish krona was devalued several times because high inflation across the Scandinavian countries made Sweden's fixed exchange rate policy untenable, and soon after that the fixed rate peg was abolished.

Fundamental to the crisis in Sweden was capital outflow on a large scale, he says.

At the time, many foreign firms did not believe that the peg would hold, and were expecting further devaluation of the currency, so they hedged their revenue and assets on a large scale, causing big capital outflows.

This situation could provide a useful lesson for China, which surprised the market in August by allowing the renminbi to depreciate by 3 percent over August 11-12, which was the largest single move since 1994.

The depreciation came just after a big crisis in China's stock market, which has lost more than 40 percent of its value since June. In the meantime, the slowing growth of China's real economy has had an unprecedented impact on global commodity prices, hitting hard the economies of commodity exporters like Canada and Australia.

Bergqvist says that while he understands the reasons for the Chinese government's currency reform and the consequent renminbi depreciation, he believes such bold policy moves perhaps came too soon, since any unexpected policy shift can deter investor confidence.

More specifically, foreign firms that have investments in China are likely to hedge the currency risk of their revenue and assets, which are priced in renminbi. This large-scale hedging could potentially cause an unexpectedly big capital outflow, despite the foreign companies' commitment to China's real economy.

According to figures from the second quarter of 2015, foreign companies have $2.83 trillion (2.58 trillion euros) invested in China, compared with $1.01 trillion of Chinese investment abroad, and this big divergence contributes significantly to China's large currency reserves. But it also demonstrates the magnitude of potential outflow.

To create a currency hedge for revenue, for example, a foreign company would typically sell an amount of renminbi at the current exchange rate for an agreed future date, to match the amount of revenue expected in renminbi on that future date. Such a hedging activity itself is the same as capital outflow.

Over the past year, the slowing growth of China's real economy has meant a decline in foreign reserves, falling by a quarterly record of $180 billion in the three months to September. But the foreign capital hedging currency risk could cause problems of a much larger magnitude, Bergqvist says.

Historically, as foreign companies have always expected appreciation of the renminbi, they did not see a need to hedge their revenue and assets, but now that the Chinese government is sending out a message that currency movements can go both ways, hedging activities are likely to take place.

"The challenge right now is for policymakers in China. You have to move very cautiously with changing the currency trend. If you change, you will change behavior among market participants," he says.

In Bergqvist's view, the recent economic slowdown and financial market instability in China has caught attention on a global scale because the global economy itself is experiencing many challenges.

"I can see frustration and fear, frustration with the slow economic growth, and fear of a new economic slowdown," he says.

From a macroeconomic perspective, Bergqvist says, it is worrying that the global economy has not fully recovered from the 2008 financial crisis, and the global debt level has increased rather than fallen.

The Bank for International Settlements says the global debt level was at a record high of 230 percent of global GDP in 2009, and this increased to 265 percent in 2014, meaning that the world economy is now more vulnerable to economic downturns.

The other big difference between the pre-crisis and post-crisis years is the increased frequency of business cycles, where economic booms and recessions happen at closer internals. This change in the business cycle pattern is making it very difficult for businesses to tell whether they are at the peak or bust of a cycle, and they will hold off investment to the detriment of the economy, Bergqvist says.

"If you can't tell where you are in the business cycle, you will postpone decisions about hiring, making investments. And if you have a question mark about China, or Grexit in Europe, or Brexit of the UK, then that's enough to make corporations concerned, and the postponement will slow down economic growth."

Among these worries globally, China is playing an increasingly different role, because the world is experiencing interdependence on an unprecedented scale, and China is a key facilitator of this integration.

"China has joined the global market with a speed and size of economy we have not seen before, and after the Lehman (Brothers) collapse, the US and Europe faced lots of problems. But we had growth in China and other emerging markets," he says.

"Meanwhile, we are concerned about long-term structural issues in Europe and the US, including demographic challenges, meaning we won't have the same level of growth as before, so to have strong growth, we rely on other countries.

After the 2008 financial crisis and the collapse of Lehman Brothers, the world financial order experienced a big change and China's increasing influence as a new bedrock of the global financial system emerged.

One reason is that China was already playing a prominent role in the world economy in the years leading up to the financial crisis, and its contribution to the global trade boom was taking place on an unprecedented scale.

"We take time to understand what happened after the crisis, and we are now looking at China as one of the most important economic drivers for the world economy.

"But this new importance of the Chinese market has meant that China bears new responsibilities, and the recent slowing of the Chinese economy and turmoil in its financial markets has caused concerns on a scale larger than its domestic economy.

"There is a factor of uncertainty, because we've never in history seen the scale of transformation as what we saw right now in China, so this makes me uncertain about where we would end," he says.

For Bergqvist, the rise of China was a "huge experiment" and the lack of similar growth stories in history makes it difficult to interpret where China will go next, and where it will take other countries.

Bergqvist says China still has room for further growth, especially by investing in social services such as healthcare and education, and this would lead to consumption-driven economic growth by reducing Chinese citizens' need to save as a security net.

Meanwhile, he says China could help to create more growth globally by opening up its markets more for foreign capital and financial investment. "As China is growing as an economy, it's important to have this free flow of people, money and investment."

Western countries need to accept and recognize that the previous levels of growth will no longer be possible because of long-term structural challenges, and they need to come to terms with China's true power, he says.

"We are a bit afraid of the power of China, and what makes us afraid is the speed of change, but if I look at the size of Chinese investments in the rest of the world compared to foreign direct investments in China, we have to be prepared for Chinese investments in the rest of the world to increase substantially.

"That will change the thinking of how you conduct business in the future. But I think that is a part of normalization."

cecily.liu@chinadaily.com.cn

(China Daily European Weekly 11/06/2015 page32)