The significance of China in participating and shaping international financial market cannot be overemphasized. Notably, as of April 2018 the country records the world’s second largest economy in terms of the Gross Domestic Product, which simply put is the value of goods and services produced with a country in one year (Krugman, P., Obstfeld, M. & Melitz, M., 2015). Moreover, the growth in Chinese economy has registered an exponential growth since the initiation of the Chinese economic reforms in 1978 from a GDP of $147.3billion to currently over $ 12 trillion. However, in the past decade, there has been a relative decline in the rate of growth to annual growth rates dropping from double figures to the range between 6% and 7% ( Cashin et al. , 2017). The changing dynamics in Chinese economy and its impact of international financial markets have been contributed to at least in part by the increasing country’s overall debt, changes in exchange rate policies, alterations in the country’s market flows.
Increasing Debt
A recent exponential increase in Chinese debt has had detrimental impact on its local economy and subsequent international economic relations. According to a recent report by the Financial Times, the ten year period between the 2006-07 financial crisis and 2016 saw the countries debt burden increase by nearly five-fold from $6 trillion to $28 trillion (Anderlini, 2017). Expressed in terms of debt to GDP ratio, this represents an increase from 140% to 260% with projections showing the figure could hit 320 by 2022 (Curran, 2018). These characteristics are evident in figure1 below. What this means is that the total debts of China is increasing at a proportionately higher rate in relation to the value of production of goods and services within the country. China’s ballooning debt was caused mainly by government’s initiative of that allowed enormous easy loans following the aftermath of the 2006-07 financial crisis. Notably, the move was politically instigated with an aim of the ruling communist party to maintain a minimum annual growth rate of 8% so as to cushion itself from possible political unrest that would challenge its authoritarian rule (Anderlini, 2017). As such, the exponential increase in China’s debt has been a major financial issues that has impacted its economy in a significant way.
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Figure 1 China's Debt Explosion 2000-2017 (Source: Bank of International Settlements)
The increased amount of China’s debt was both advantageous and similarly detrimental to its local economy and international finance relations. In the short-term, this government input of opening credit floodgates was beneficial because it ensured a continuous sustainable growth in the economy. However, in the long run the level of debt that the country finds itself in will offer special challenge to its economic progress and international financial situation. A statement by the International Monetary Fund (IMF) on this issue noted that International experience suggests that China’s credit growth is on a dangerous trajectory, with increasing risks of a disruptive adjustment and/or a marked growth slowdown (IMF, 2016). The level of China’s debt is beginning to attract international concerns as pointers towards a crisis are eminent. According to Cuestas & Regis (2018), some of the metrics used by the Bank for International Settlements to determine the chances of a financial crisis are beginning to flash red. In particular, the ‘credit-to-GDP gap’, which measures the differential between the debt-to-GDP ratio and its long-run trend, is estimated to be about 30 percentage points extremely high by any measure. Evidently, although the growth in China’s credit has been an impetus for its economic growth over the past decade, the levels currently portend a challenge both locally and for the international markets.
China’s Exchange Rate Policies
In the financial market, exchange rate policies refers to the general set of rules and regulations that an authority uses to manage its currency in relation to other currencies and the foreign exchange market. Such policies have an effect on the relative strength of the currency over other currencies. With regards to the China, the country had several changes in is exchange rate policies which have had significant impact to the international financial market between the country and partner trading nation. Before delving into discussing how China’s exchange rate policy has been changing it is important to understand some concepts with regards to the regulation of foreign currency exchanges. According to Mertens & Shultz (2017), exchange rate stabilization, simply known as currency “pegs” is an important intervention that are used in international financial markets. In essence, if a country removes a peg it initially had on a safer currency makes the local currency more risky to invest in owing to its likely volatility. Moreover, if the country that is removing its peg from a safer currency has a significant influence on the market, then investors remain in limbo as holding either currency could be associated with significant risk (Mertens & Shultz, 2017). As such, foreign exchange policies have an impact on the international financial market and subsequently on international trade.
China has repeatedly changed its foreign exchange policy over the past decades impacting its trade relations with other countries. According to a report by the IMF, the policy by the People’s Bank of China (PBOC), the country’s central bank, was classified as a conventional peg to the U.S. dollar from 2003 to 2005. This changed between 2006 and 2008 as the renminbi (the Chinese currency) gradually appreciated under a policy classified as a crawling peg to the U.S. dollar. The two currencies were stabilized between 2008 and 2010 and this changed again in 2010 owing to a policy change to a “crawl-like arrangement” relative to the U.S. dollar. A significant policy change occurred in 2015, the China Foreign Exchange Trade System (CFETS), a division of the PBOC, published an exchange rate index of 13 currencies in an effort to shift markets away from interpreting renminbi exchange rate movements as being driven only by its connection to the U.S. dollar (CFETS, 2015). In order to put all these into perspective, it is important to highlight what impact these policies have on the Chinese currency relation not only to the US dollar but to other currencies as well.
The policy that stabilized the renminbi against the US dollar led to a decreased interest rate differential between the two countries and decoupling the two currencies through policy change gives lee way for the spread in interest rates (Hassan et al., 2016). However, when using a basket peg the degree of change of the exchange rates between the two currencies is varied greatly. Since the U.S. dollar is a safe haven currency, the change in policy would improve the attractiveness of U.S. assets and put downward pressure on U.S. interest rates. Conversely, by loosening the peg to the U.S. dollar, the renminbi no longer inherits the safe haven properties and becomes less attractive to international investors. As a consequence, China’s interest rates increase (Mertens & Shultz, 2017). Coupled with China’s increasing debt to GDP ratio, many Chinese investors are increasingly looking for foreign currencies such as the US dollar as safe haven, which will provide a more challenge for the PBOC to perform its primary mandate of maintaining financial stability.
China’s Capital Flows
The understanding of China’s nature of and regulations of capital flows is essential in holistic understanding of the country’s role in international economics. Initially, it is important to clarify the meaning of capital flows which simply put refers to efer to the movement of money for the purpose of investment, trade or business production, including the flow of capital within corporations in the form of investment capital, capital spending on operations and research and development (Glick & Hutchison, 2009). Notably, cross-border capital flows are not only governed by government policies but also by systematic response of investors to periods of economic acceleration. China has grown to dominate global commodity and export markets and is currently the world leader with regard to its share of the pool of global liquidity. Additionally, the PBOC boasts of a balance sheet of $5.2tn as of December 2018, marginally second only to the European’s Central Bank’s balance sheet of $5.3tn. Clearly, China is placed as an important player in the global economy as it may be the biggest national economy that the world has ever seen. Such progress in Chines economy is likely to initiate a response from other influential contributors to the international financial markets. Accordingly, the US Federal Reserve, the Bank of England and the European Central Bank all look set to tighten their monetary policies over the next year (Howell, 2018). Clearly, the exponential growth in China’s economy which has been witnessed in the last few decades has the potential of causing important policy formulations for other economies in the change in capital flows.
Conclusion
China is an important player and influencer in international financial markets not only in relation to the US but to other economies too. Notably, the China’s economy has a for a long time since the 1978 Chinese economic reforms registered double digits of annual growth. However, due to a number of macroeconomic factors, this growth has declined with annual rates of growth falling to between 6% and 7% in the last decade. From the literature review, it is clear that the country’s expansive local debt, the changes in exchange rate policies, and changes in capital flows have weighed in significantly in impacting China’s local and international financial market.
References
Anderlini, J. (2017), China’s economy is addicted to debt | Financial Times Retrieved from https://www.ft.com/content/293f8f22-8112-11e7-94e2-c5b903247afd
Cashin, P., Mohaddes, K., & Raissi, M. (2017). China's slowdown and global financial market volatility: Is world growth losing out?. Emerging Markets Review, 31, 164-175.
China Foreign Exchange Trade System (2015). The Launch of RMB Index Helps to Guide Public View of RMB ExchangeRate. Retrieved from http://www.chinamoney.com.cn/english/bmkidxrud/20151211/854.html
Cuestas, J. C., & Regis, P. J. (2018). On the dynamics of sovereign debt in China: Sustainability and structural change . Economic Modelling , 68, 356-359.
Curran, E. (2018) The Biggest Threats to China’s Economy in 2018 | Bloomberg Retrieved from https://www.bloomberg.com/news/articles/2018-01-01/china-warms-up-for-2018-critical-battles-with-cooling-economy
Glick, R., & Hutchison, M. (2009). Navigating the trilemma: Capital flows and monetary policy in China. Journal of Asian Economics , 20(3), 205-224.
Hassan, T., Mertens, T. & Zhang, T. (2016). Not So Disconnected: Exchange Rates and the Capital Stock. Journal of International Economics 99(1);43–57.
Howell, M. (2018) The loud warning noises from Chinese capital flows | Financial Times Retrieved from https://www.ft.com/content/2a46b5bc-43c2-11e8-803a-295c97e6fd0b
International Monetary Fund (2016). Annual Report on Exchange Arrangements and Exchange Restrictions. http://www.imf.org/en/Publications/Annual-Report-on-Exchange-Arrangements-and-ExchangeRestrictions/Issues/2017/01/25/Annual-Report-on-Exchange-Arrangements-and-Exchange-Restrictions-2016-43741
Kapur, R. (2017) Understanding the Biggest Challenges in the Chinese Economy Today | Treasury, Financing, and Accounting Geeks Retrieved from http://tfageeks.com/2017/08/24/chinese-economy-challenges/#
Krugman, P., Obstfeld, M. & Melitz, M. (2015) International Economics: Theory and Policy Upper Saddle River; London: Prentice Hall
Mertens, T. & Shultz, P. (2017) China’s Exchange Rate Policies and U.S. Financial Markets FRBSF Economic Letter 28(2); 1-4
