In China, stock market volatility is symptom, not disease: Stratfor, Jan 7, 2016

The start of 2016 has been rough for China. Monday saw the introduction of a new mechanism in the Chinese stock market: a circuit breaker that automatically shuts the market down if prices go into free fall. Within four days, the circuit breaker went into action twice, halting trading on two different days in an attempt to stop the decline. Though this might be worrying for the Chinese government, it is not new; a study shows that if such a circuit breaker had existed last summer, it would have been triggered at least 20 times.
In truth, this activity in the stock market pales in significance to the other major development of the week: Thursday’s announcement that China’s foreign exchange reserves dropped by a record amount in December, from $3.4 trillion to $3.3 trillion. That brings last year’s total decline in foreign exchange reserves to $513 billion.
If the stock market woes are evidence that investors are losing faith in the Chinese economy, theforeign exchange reserve depletions are direr, because they signify the Chinese government’s diminishing ability to cope with its problems. Beijing’s inability to control its economy has global implications — such as contributing to an extended period of low demand, and thus low prices, for oil and other commodities — but it also highlights China’s struggle in balancing some of its short-term financial market concerns against its long-term and much more important overall political and economic reforms.
Worrying about the level of foreign exchange reserves is relatively new for China. As China kept its low peg to the dollar and exported vast quantities of goods, foreign currency gushed into the country for much of the past two decades. From the perspective of international financial markets, high levels of foreign exchange reserves are a source of comfort. They give a country the power to defend its currency, and any government that allows its reserves to run too low runs the risk of becoming victim to speculators. China has thus spent much of the past two decades creating for itself a seemingly invincible position, building its reserves from $142 billion (18 percent of gross domestic product) in 1997 to $4 trillion (43 percent of GDP) in 2014. However, this invincibility — both in foreign exchange reserves and, more broadly, the health of the Chinese economy — is now coming into question as a result of both internal and external forces.
The United States began tightening its monetary policy with the Federal Reserve’s interest rate hike last month. This caused the dollar to appreciate, meaning that the yuan, which was de facto pegged to the dollar, rose along with it. Meanwhile, the investment capital that China was pumping into its own economy as part of its post-2008 model found its way into the domestic stock market, blowing a massive speculative bubble that peaked in summer 2015. The bubble deflated somewhat in August, when the People’s Bank of China announced a shift in its currency peg that the market took as a signal that the yuan was set to depreciate. As a result, in the second half of 2015, China introduced measures to sustain stock prices, including both capital injections and enforced freezes on selling stock, while trying to maintain its currency peg in order not to spook the markets even more. All of these things cost money, and the funds came from the foreign exchange reserves.
The loose monetary policy that keeps funds flowing into stocks also costs money because it applies a depreciatory force on the yuan as capital flows out of the country (defying capital controls in the process). The currency must then be propped up with foreign exchange reserves. Thus, since mid-2015, China’s foreign exchange reserves have been depreciating rapidly. In October, the drop broke a quarterly record, and the December figures set a new monthly record.
Although the stock market is getting a lot of attention, China’s macro-economic picture also offers little cheer. The continued slowdown in industry — such as hints of sluggishness in the service sector — is one of several larger underlying problems China is struggling to deal with. China’s difficulty in managing its stock market, foreign exchange reserves and currency regime is merely a reflection of those core issues.
China’s is a structural problem, and the fix requires a long time and a lot of disruption. Many of the major reforms needed to solve these problems quickly become points of political friction. For example, reforming the country’s household registration system (known as hukou) is an integral part of creating an urban consumer class. However, the conversion of rural migrants to city dwellerswould force cities to expand social services. Hukou reform then becomes a key political issue between central and local governments over the costs of expanded social services for new urban migrants.
So, as we saw in Europe, economic and financial issues are growing into political issues in China. In Europe, it was the revival of nationalism and national self-interest. In China, similar issues of regionalism will arise. But this all occurs under a single central party, so it is a twofold crisis — one of central macro-control versus local interests, and one of the very purpose and strength of the single-party system. China will continue to have short-term market effects on matters such as the demand for commodities, but there is a larger and more significant issue.
That issue is whether China can make the transition in its structure, how long it takes, whether it is managed or chaotic, and whether the current political structure holds together or breaks apart. This is a long story — one that unfolds over a couple of years, that will have peaks and troughs, moments of chaos and moments of seeming success. But it is a holistic story more than a story of discrete events or discrete numbers. It is a story about whether China emerges as the next major power, whether China remains a second-tier power that can manipulate variable coalitions to exert influence, or whether China finds its relevance waning. https://www.stratfor.com/geopolitical-diary/china-stock-market-volatility-symptom-not-disease?login=1