Can China isolate itself from global financial risks?

By Yi Xianrong Source:Global Times Published: 2018/8/20 23:03:39

Illustration: Luo Xuan/GT

The Turkish lira crisis has continued to worsen, shaking global stock markets as well. Asian and emerging markets were damaged the most, and the damage also spread to the US stock market.

The US economic sanctions were the last straw in crashing the Turkish currency. Most people believe that US President Donald Trump chose Turkey as the target because he had done the math. As such a small entity, a collapsed Turkish economy would have only a limited impact on the world.

Also, the aggregate weight of Turkish companies in the MSCI Emerging Markets Index is still low. There was not expected to be any spillover effect. Plus, emerging markets' economic fundamentals have been well off compared with the past.

Most of these countries have managed to keep current account deficits, government borrowing in foreign currencies and inflation within targeted intervals. These all ease the consequences of the lira crisis.

Despite this line of reasoning, it is still uncertain whether the Turkish lira crisis will trigger financial crises among the emerging countries or even on the global level. The global economy and financial integration have reached a peak with algorithmic trading. The market response to a major event cannot be predicted solely by indexes. An economic shock seems inevitable.

The lira crisis continues. The lira has constantly hit new lows against the US dollar, and other emerging market currencies slid as well.

The internal reason - a fragile Turkish economy - is the main cause, aside from the US sanctions. So an impact on emerging markets is unlikely to be averted since the Turkish economic situation will take time to fix.

Turkish President Recep Tayyip Erdogan has adopted economic reforms since he assumed Turkey's prime minister in 2003. Turkey's economy was on the fast track, but its economy relied on heavy borrowing, leveraged by local governments, banks and enterprises. When global quantitative easing brought down financing costs, a massive amount of dollar-denominated bond issues followed.

While pumping up economic growth, the negative side effects are also obvious. Government spending has largely exceeded income. Together with fiscal and current account deficits, this will easily push up inflation and worsen the real economy.

The worsening real economy, the US dollar getting stronger since earlier this year and Turkey again failing to get accepted by the EU have all generated a negative influence. The government could not produce the monetary and economic policies that were expected.

Investors lost confidence, resulting in capital outflows. Some short-term measures can be used such as tightening monetary policy and foreign exchange restrictions. But lifting the Turkish economy from rock bottom will not be easy. The current crisis will need deep reform to cure fundamental economic fragility.

This means a lot to China. Since China-US trade friction erupted, there have been calls within the country for ramped-up institutional reforms of China's financial management system to win the trade dispute. To live up to ideals within a brief period is not an easy undertaking, especially when China's financial system remains fragile.

In recent years, there have been signs of monetary easing in China, exacerbating its financial market fragility. Therefore, the government has put a priority on preventing systemic financial risk since last year. But in the wake of the trade spat between China and the US, there has been a shift toward monetary easing again as the country works to tackle the dispute. This will naturally affect a comprehensive overhaul of China's fragile financial system. As a consequence, systemic financial risk may easily affect China at any time.

Furthermore, it's not easy for China to isolate itself from risks brewing in the global financial markets amid economic globalization and financial integration. The yuan's rapid depreciation against the dollar appears to be offsetting rising export costs caused by higher tariffs imposed by the US. But this has surely triggered capital outflows and yuan sell-offs in the offshore market.

Viewing the yuan's conspicuous slide, the government tends to believe in its capacity to curb capital outflows, which might not be an easy task. An excessive yuan depreciation would intensify the fragility of China's financial market.

The China-US trade dispute has mostly affected China's stock markets. The key Shanghai Composite Index has shed about 20 percent so far this year, indicating a bear market on the Chinese mainland. In contrast, Indian and US stocks have continued an upswing.

It's not just a stock index's performance that matters, but how investor confidence in a bear market could be restored. If investors lack confidence in a stock market, a country's financial system will become even more fragile.

Turkey's currency crisis has offered a clue: It's most important to improve China's financial system to isolate the country from international market turbulence. 

The author is a professor with the School of Economics at Qingdao University.


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