The year could not have begun worse for China. Stock markets plummeted not only once, but twice. Government intervention failed not only once, but twice. Economic alarm signals rang not only once, but twice. And still: That does not mean crisis.
What happened in the past days is important. However, as important are its reasons. So, why did the exchange markets take a dive?
First, China’s manufacturing report was a major disappointment, showing that, so far, Beijing’s fiscal and monetary stimulus has had only a limited impact. Second, on Jan. 8, the restrictions imposed on large shareholders preventing them from selling shares — introduced last summer — were to be lifted. Traders wanted to get ahead of that. Third, the ongoing devaluation of the yuan has spooked many investors.
Note that all these reasons relate to ill-designed interventions by the state in the economy. So why did these policies fail?
The fiscal stimulus was directed toward the construction and heavy manufacturing sector. The problem is that last year, for the first time, the services sector overtook construction and manufacturing as the motor of China’s economy, so the government was incentivizing the wrong sectors.
Restricting shareholders is an even worse idea, because it calls property rights into question. However, without property rights, there is no functioning markets. This applies especially to stock exchanges. As in the minds of investors holding shares became a risk, they were more than eager to divest. So, the race to the bottom began. By the way, arresting all those “evil” short-sellers, a measure imposed in the first week of this month, further exacerbated risk perception.
Then there is the case of devaluating yuan. This, too, was a measure imposed by the central bank in order to make the manufacturing sector more attractive and at the same time reshuffle national debt. However, as devaluation is expropriation, investors also reacted to that.
Central planners estimate that China needs another US$5.7 trillion stimulus to get back on track. At least. They are wrong.
They are wrong because all past monetary injections did not help. They either increased the pressure on the economy or showcased to the world the limits of central planning. However, most important of all: Stimulus after stimulus decreased Chinese productivity.
Here is where the problem lies. Luckily, it is also where the solution is. State-owned enterprises, which are abundant in the construction and manufacturing sector, were the main recipients of fiscal aid. Due to this aid, they were never under pressure to streamline capital costs, train employees, simplify structures or innovate.
Privately owned enterprises, on the other hand, many of them small and medium-sized businesses, did not get government regalia, but in order to survive, they increased productivity and innovative capability. These agents of the economy are thriving, especially in the services sector. It is this sector that is becoming the new motor of China’s economy.
However, if China is to rely on them, its self-perception is going to have to change. These smaller and private companies cannot be regulated by a central authority. Also, they can fail and must be able to fail. Only then, entrepreneurs would be willing to take risks and innovate. Also, the decades of high GDP growth would be over.
However, this could be a much more organic and equitable growth. It is driven by productivity. It is an increase in productivity that makes people better off and more innovative. All of this is becoming reality in some parts of the Chinese economy. If only the government would let it spread.
Henrique Schneider is chief economist of the Swiss Federation of Small and Medium Enterprises.
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