The rules of the game matter

3 minute read

China’s emergence from a low- to a middle-income economy has been one of the largest transitions in economic history. Yet, the sustainability of this journey has often been questioned. Increasing imbalances before 2007, a rising debt burden after 2008, the currency regime shifts in 2015 and 2016, as well as the impact of increasing protectionism, have been named as obstacles to China’s economic prosperity. More recently, new regulatory frameworks have brought into question China’s economic development, in particular its path towards a more liberal economy. In this blog, I elaborate on current developments in China and provide the reader with some background information on the rules of the game.

Chinese capital markets reacted violently to the recently introduced regulations in the tech and education industries. With respect to the latter, industry players could be turned into non-profit organisations with restrictions on capital raising, mostly with respect to foreign capital. Also, more measures to cool housing prices were introduced recently. The above should establish greater fairness in the Chinese economy; social welfare, as well as wealth redistribution, are preferred over less volatile capital markets.

Strategic goals, such as increasing the incomes of a large part of the society and population growth, underline the recent steps towards more stringent regulations. More equal growth leading to common prosperity is the goal; social merits and improving equality are policy priorities for the Chinese state capitalist system. This should lead to greater stability in the long run, even though capital markets reacted in a volatile manner with respect to the steps taken by Chinese authorities.

Why did volatility in Chinese capital markets increase substantially over the last weeks? The new regulations certainly entail some uncertainty, leading to a higher country risk premium. Policy errors never can be excluded, and business risks get reflected in capital market valuations. The magnitude of the sell-off in equity markets approaches the correction of 2018 in which tighter shadow banking regulations, as well as the US-China trade tensions, also led to significant volatility.

However, the new regulation addresses previous market concerns and should lower systemic risks in the long run. Previous cycles, such as the above-mentioned regulatory tightening in 2018, entailed positive effects for the Chinese economy. Also, the anti-corruption campaign of Xi Jinping led to reduced rent-seeking behaviour, improving equality and the effectiveness of the Chinese economic system.

Currently, loopholes in the system are addressed by Chinese policymakers. The market power of tech giants stifles innovation and social issues were the reasons behind the reforms in the education system. The question is whether the Chinese state capitalist system can fix the loopholes by actively intervening. Capital markets seem to doubt this, although recent regulatory moves could lead to enhanced innovation, as well as market competition in the long run.

China aims for common prosperity in the current stage of its development. The country was largely successful at alleviating extreme poverty and now more redistributive measures aim at a higher level of equality.

What the market is concerned about is that the Chinese state hampers market incentives by actively intervening in industries. It seems, however, that policymakers prefer a higher level of equality to reacting to capital market signals. The common prosperity vision of China still entails some differentiated levels of wealth but should enhance income for a broader part of the population.

To strike a balance between social equality and market-led growth is not an easy task. The promotion of healthy development via increased regulation should have long-term benefits, but at what costs in the short term? The balance between business, security, and fairness is not easily met. Different systems have different approaches with respect to the latter.

It is important to say that China remains committed to a more liberal economy and that recent steps should not be interpreted as a reduction in the willingness to open markets. The overarching objective is to promote fair and efficient growth at the same time as containing systematic risks. Capital markets should regard this as a positive.