Faculty Interview: A Discussion with Paul Armstrong-Taylor

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Paul Armstrong-Taylor is the Resident Professor of International Economics at John Hopkins School of Advanced International Studies, Nanjing University, China, where he teaches classes on finance, strategy and the Chinese economy. His professional experience includes positions as a consultant at Monitor Group and London Economics and as an investment banker at Morgan Stanley.

Professor Armstrong-Taylor received his Ph.D. in Economics from Harvard University. He has published numerous articles on China and the economy for academic and non-academic media. He is the author of the forthcoming book Debt and Distortion: Risks and Reforms in the Chinese Financial System.

Recently, the SAIS Observer sat down with Professor Armstrong-Taylor to discuss some important developments in China’s economy in 2015.

Part I: The stock market tumult.

Though China’s 2015 stock market turmoil drew international attention, in the mid-2000s, the Shanghai Composite saw an even more dramatic cycle of boom and bust. How likely is that we will see another bubble in the future?

While bubbles and crashes are part of stock markets, it is unusual for a stock market to experience two such sizable bubbles within a decade. However, there are some special features of China’s stock markets that make them particularly prone to bubbles.

What are the key structural factors that contribute to this tendency?

Firstly, unlike most other stock markets, retail investors (that is, individuals rather than institutions) dominate trading in China’s stock markets and many of those individuals are poorly educated. Such investors may be more influenced by psychological biases: for example, buying stocks that have gone up (exacerbating the boom) and selling stocks that have gone down (exacerbating the bust).

Leverage — that is, borrowing money to buy stocks — amplified the recent bubble. Buying stocks on margin was not legal in 2007, but played a big role in the recent bubble. In addition, some investors may have borrowed from other sources to buy stocks. Borrowing to buy stocks can amplify the bubble: the more you borrow, the more stocks you can buy and so the more money you make; and the more investors borrow, the greater the demand for stocks and so the more the price goes up. However, these factors reverse when prices fall: losses are amplified and some investors must sell to pay back loans. Leverage is often a factor in bubbles and certainly seems to have played a role in China’s recent bubble.

What kind of role did government policy play in the run up to and aftermath of the bubble?

Chinese investors, probably correctly, view government policy as the key driver of stock market returns — at least in the short-run. There is a widespread belief that if the government wants the stock market to go up, then it will go up. In the United States, investors often say “don’t fight the Fed” and in China the equivalent rule is “don’t fight the government.” Throughout the formation of the bubble, the government was indicating that it approved and supported the increase in stock prices which encouraged investors to pile in. In my view, this was deeply irresponsible and left the government in an awkward position when the bubble burst. If it allowed the market to fall, it would hurt their credibility and popularity: investors who had bought stocks with government encouragement would not feel happy losing their money. If it intervened, it would undermine market forces and set back its commitment to financial reform. Of course, it chose the latter. This may have reduced short-term costs, but it has seriously damaged the credibility of the government on financial issues. International investors will be wary of investing in Chinese markets when government policy is so fickle.

Following the bubble, it was reported that Chinese officials were considering increasing the regulatory power of the People’s Bank of China, or, alternatively, creating a new organization that would unify banking, insurance and securities regulators. Which of these plans represents a better path forward?

A unified regulator, whether the PBoC or a new institution, avoids some of the problems arising from multiple regulators. It is less likely that jurisdictions will overlap or leave gaps. In addition, it is easier for a “super-regulator” to manage systemic risks — risks that arise not in one sector but in the interaction between sectors. For these reasons, some developed countries have given increased regulatory power to their central banks.

There may be some advantages to placing this regulatory power under the PBoC rather than a new body. The PBoC has been the part of government that demonstrates the best understanding of the financial system and which has most strongly supported financial reforms. Through its roles as setter of monetary policy and lender of last resort, it has a substantial influence on the financial sector, which would have to be considered by any regulator. These functions might be easier to perform if the regulator was PBoC itself.

Part II: The Exchange Rate, Interest Rates, and Financial Reforms

How well did the PBoC handle the 2015 devaluation of the renminbi?

The renminbi is linked to the dollar, so as the dollar has appreciated sharply against most other currencies, the renminbi has appreciated with it. On a trade-weighted basis, the renminbi has appreciated by about 30% in real terms since 2010. As a result, the renminbi is probably 10% or so overvalued currently. This places pressure on exports and is contributing to the slowdown in the Chinese economy.

A cheaper renminbi might boost the Chinese economy and make opening the capital account less risky, but devaluation is not easy. If it is done suddenly, it would create turmoil in the financial markets. However, if it is done slowly, speculators will pick up on the trade and dump renminbi, which would make it even harder to control the exchange rate.

This is the background behind the devaluation in September. The PBoC was criticized for triggering panic by not communicating its intentions. However, if it had communicated its intentions, speculators would have sold renminbi ahead of the devaluation, which would have made management harder. Perhaps the devaluation was not handled well, but it is not clear if there is a good way to do this.

Given this reality, is there any effective way of devaluing without causing contraction or fiscal turmoil?

Recently, the PBoC has indicated it wants to tie the renminbi to a basket of currencies rather than just the dollar. This may make sense and will allow the renminbi to depreciate against the dollar in a controlled way that is understood by the markets. On the other hand, this would seem to encourage speculators to bet on devaluation against the dollar which would accelerate outflows. Nevertheless, this policy may be the best shot the PBoC has at devaluing with minimal cost.

In the last year, the PBoC has lowered the benchmark rate six times. What has this achieved and what are the main risks it might produce?

Though the benchmark rate has been lowered repeatedly, it is not clear that monetary policy is easing in China. It is true that interest rates have fallen, but inflation, at least for producers, has fallen as fast or faster. As a result, the real interest rates (nominal interest rate minus inflation) faced by many firms has increased, making borrowing harder.

In addition, as mentioned above, the decline in foreign exchange reserves acts as quantitative tightening. This has been partially offset by reducing the reserves banks are required to offer so that they can lend more, but the net effect still appears to be contractionary.

This might be a deliberate attempt to reduce borrowing. Since 2009, debt has increased sharply in China, which may have encouraged both wasteful investment and leveraged speculation. Continued expansion of this debt would increase the risk of a financial crisis, but slowing it will slow the economy. Again, the challenge faced by the PBoC is not easy to overcome. A very loose policy could lead to a crisis, but a very tight one could lead to a severe recession.

The PBOC essentially completed deposit rate liberalization in 2015. How much of an effect have these changes had and what areas should future reforms to China’s financial system focus on?

China completed the liberalization of bank interest rates in October by removing the ceiling on deposit rates. As most banks are still state-owned, the government retains some influence over interest rates, so it may be too soon to say that interest rates are entirely market driven, but the liberalization over the past couple of years is clearly a move in that direction. Liberalization may have been accelerated because banks were losing deposits to competitors (for example Alibaba’s Yu’e Bao) offering higher, market-based rates. As a result, bank opposition to liberalization was muted and the reforms could move swiftly.

The progress on bank interest rates is in stark contrast to the heavy intervention in the local government bond market. Low-rate bonds were floated as a way for local governments to pay back their expensive bank loans. Unfortunately, investors felt these interest rates were insufficient to compensate them for the credit risk and refused to buy. A combination of government carrots and sticks forced banks to buy the bonds at low interest rates, making local government bond rates clearly not market-based.

Interest rates in other areas are distorted by government guarantees. Borrowers who are believed to have government backing can borrow at low rates regardless of their financial condition. This has exacerbated overcapacity in some industries (e.g., steel) by allowing loss-making firms to continue to borrow rather than being forced to close. Removing these distortions is one of the big challenges of financial reform.