Why Is China Losing Economic Momentum? A Global Finance Discussion

Bob Gross

Wednesday, July 29, 2015

The recent press has been full of news about the downdraft in China’s stock market. While there are a number of valid fundamental financial issues that have been cited as reasons, there is another that has only been vaguely alluded to. I’m referring to the role that China’s government has played in both the rise and fall in its stock market.

The roles that sovereign governments play in their capital markets have long been discussed in economic circles, and the resulting action steps taken by a given central government can vary around the globe and also with the passage of time. Accordingly, being aware of a specific government’s initiatives is an important consideration is assessing global financial dynamics and risks as US-based companies evaluate and implement global expansion.

Being disciplined about the interpretation and analysis of this source of risk is a core thread that runs through all aspects of our Global Finance course at LFGSM and we’ve introduced one word (new to almost all students) that becomes helpful in our dialog. That word is ‘Trilemma’. This term as applied to economics is also referred to as the ‘Impossible Trinity’, and suggests that a given nation can’t simultaneously control all three of these key elements of their economic policy:

  • Fixing their exchange rate
  • Constricting the flow of capital
  • Controlling their monetary policy

The Trilemma theory suggests the best they can do is control two out of three, and if they try to control them all for a prolonged period, something will give. In our Global Finance course, this concept comes up frequently as we seek to understand and discuss current and historical events that impact global risk.

So, let me ask two questions of you (and in particular our past Global Finance students): (1) Has China tried to fix all three elements in the recent past and (2) Might something be giving way right now? I encourage students and faculty to share your comments and insights below.

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Bob Gross teaches Financial Management and Global Finance at Lake Forest Graduate School of Management. Bob is also the Co-Founder and Senior Managing Director of Prairie Capital Advisors, Inc. Prairie is an employee-owned company that provides investment banking, ESOP advisory and valuation services to support the growth and ownership transition strategies of middle-market companies. Bob has a passion for staff development, and he speaks to audiences on a wide variety of corporate finance topics, including valuation, mergers and acquisitions, ESOPs, ownership transition, securities design, and synthetic equity. LinkedIn

 

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  • Matt Stawiarski

    China has tried to control all three in the past decade or so but things are changing in current economic environment. China’s emphasis to artificially set its exchange rate has allowed them to export goods across the world much cheaper than others. As of recent pressure from foreign governments (mainly US), China has allowed currency to appreciate or partially float due to market forces. The decision to do this has sparked an influx of capital from currency speculators looking to make a quick buck and give banks surplus reserves.

    The challenges moving forward for China as it tries to rebalance its Trilemma are numerous. China wants to be a world reserve currency but cannot until it fully allows Yuan to float in global market. Allowing the currency to float potentially will lead to currency depreciation which will lead to capital outflux. This will hurt the overall economy as having a credit crisis and bring overall debt issues to the surface. China also will have to address an economy that has a growing middle class where workers will demand higher wages. In addition China’s economy will shift from being an export dominant country to one of consumption. The final piece to the puzzle will be trust and transparency in the financial system of China.

    Side note: there was an interesting article in the WSJ today in regards to Yuan

    http://www.wsj.com/articles/bets-rise-that-chinas-yuan-will-fall-1438239578