Three Reasons Why Concerns About China's Market Turmoil Are Growing

A scary sell-off in Chinese stocks is magnifying concerns about the health of the world's second-biggest economy.

A scary sell-off in Chinese stocks is magnifying concerns about the health of the world's second-biggest economy.

The Shanghai Composite Index on Thursday tumbled 7 percent in 30 minutes before trading was suspended. The damage quickly rolled around the world: Stocks plunged in Tokyo, Hong Kong, London and New York. The Dow Jones industrial average finished Thursday down a steep 2 percent. On Friday, the Shanghai Index closed up 2 percent.

China's stock markets have little connection to the rest of its economy. A big reason Chinese shares are sinking is that Beijing is trying to undo some of the measures it took to prop up stock prices after the Shanghai market collapsed in June. Yet China watchers say there are reasons to worry about the Chinese economy.

Among them:

A Weakening Currency

The Chinese government alarmed world markets in August by suddenly pushing down its currency, the yuan, by about 2 percent. Pessimists feared that the devaluation signaled desperation: Maybe Beijing had grown so worried about the country's economic prospects that it had decided to give its exporters more help by lowering the yuan's value, which makes Chinese products more affordable in foreign markets.

The government said it was merely responding to signals from the market: The yuan, closely linked to a surging U.S. dollar, had risen too high. After the August devaluation, the yuan stabilized for three months. Then it started sinking again. It's dropped more than 4 percent against the dollar since the end of October. On Thursday, the yuan hit its lowest level against the dollar since 2011.

The Chinese economy has been "weakening for years," says Derek Scissors, resident scholar at the conservative American Enterprise Institute. "That hasn't changed. What has changed is they pushed the yuan down.

"There's a heightened risk that the Chinese are going to be more aggressively predatory on trade," he said. "Everybody who competes with China β€” their profits are now in jeopardy."

Scissors says he thinks the Chinese authorities are actually just catching up with reality, not trying to give their companies an unfair edge. The yuan, he says, is still overvalued.

"If you left it alone, it would probably fall another 5, 6, 7, 8 percent," says Yukon Huang, senior associate at the Carnegie Asia Program.

Chinese authorities want to keep the yuan from going into free-fall. But investors who fear that the currency has further to fall are likely to sell investments that are denominated in yuan, thereby putting further downward pressure on China's currency and stocks.

A Tough Transition

China's economic slowdown is partly deliberate. The country's super-charged growth of the past quarter-century was built largely on massive investment in real estate and factories, much of it increasingly wasteful and inefficient.

The government is trying to guide the economy toward slower but more sustainable growth built on spending by Chinese consumers. It's also nudging the country away from overdependence on manufacturing toward more reliance on services industries.

Overhauling a sprawling and enormously complex economy was always going to be daunting. And a report Wednesday, seized on by global investors, suggested that the transition might not be going so well, at least not yet: The Caixin China General Services Index fell last month to its second-lowest level in records dating to 2005.

The index showed that far from picking up the slack from faltering manufacturers, Chinese services businesses are barely growing. Moreover, the report noted that services firms weren't hiring fast enough to offset factory layoffs.

Economic Mismanagement

Chinese policymakers, long admired for their stewardship of a fast-growing economy, have worsened things by communicating poorly, meddling clumsily in the markets and backsliding on reforms.

"The ongoing rout in China's stock and currency markets reflects a sharp erosion of confidence in the economic management skills of Chinese policymakers, coupled with rising concerns about the state of the economy," says Eswar Prasad, professor of trade policy at Cornell University.

The government's heavy-handed attempts to stop a freefall in the Shanghai stock market dismayed those who had hoped China was moving toward a more open financial system. Chinese authorities banned investors from betting against stocks, suspended trading in hundreds of companies and poured money into the market. At first, the desperation measures seemed to work. Yet stocks plunged again once the government began to back away.

What's more, the authorities have repeatedly confused investors about their policy toward the yuan, thereby unnerving the markets.

"You have to explain what you're doing," Huang says. "The Chinese economic managers are not good communicators."

The uncertainty coincides with persistent doubts about China's economic statistics. Even Premier Li Keqiang has conceded that Chinese figures for economic growth are "man-made."

Officially, the Chinese economy grew about 7 percent last year. Some economists suspect the actual growth rate might be 6 percent or lower.

"I wouldn't be surprised to see it decelerate to the 4 percent range this year," says Daniel Meckstroth, chief economist at the Manufacturers Alliance for Productivity and Innovation.

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