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There is a growing risk that China will be the origin or epicenter of global economic turbulences. To prevent negative spillover effects from homemade shocks, China has to improve the quality of economic data, set more realistic targets, improve communication and rely on market signals.

Shenzhen Stock Exchange headquarters by OMA/ Rem Koolhaas

China has a good record in leaning against the wind of global economic turbulences. In the aftermath of 9/11, China helped to prop up financial markets by abstaining from a panic sale of dollar-denominated assets. Seven years later, during the US sub-prime crisis, the Chinese government launched the world’s largest fiscal expansion program to prevent a long worldwide recession. Today, China pays the price for this overinvestment as excess capacities in many industries now plague the country in times of lower domestic and international demand.

In the current scenario, the next big economic shock is not unlikely to originate from China. A change of course in China’s industrial policy to initiate overdue structural reforms could send shock waves through the real economy. Add to this the uncertainties surrounding the internationalization of the RMB and the opening up of Chinese financial markets, and the question is out: How will China right the ship when the wind blows from its own shores?

Growing risk of economic shocks from China

The International Monetary Fund has warned of the growing danger of economic and financial crises spilling over from China. The regular Article IV Consultations Report of July 2016 as well as a recent Working Paper by IMF staff members conclude that shocks in China’s real economy and financial system can be transmitted via traditional trade links but increasingly also via financial markets, rattling neighboring Asian countries first and eventually affecting the entire world.

This assessment is no doubt informed by the sobering experience of how strongly international financial markets reacted to China’s ineffective operations during the exchange rate turbulences in August 2015 and thereafter. Instead of giving markets clear signals, China’s authorities erratically switched between exchange rate targeting and exchange rate flexibility. Of course, they are still learning how financial markets react under unexpected events and stress. But the way they mishandled volatile movements in financial markets also point to deeper dilemmas in the management of the real sector: while the goal is to move away from its traditional export orientation, allowing the currency to depreciate would contribute to cementing the old model.

To ensure better economic policy implementation, China mainly has to address four issues: It needs better data quality, fewer conflicting targets, better communication, and, finally, less bureaucratic intervention and greater responsiveness to price signals and market reactions.

Steps to better economic policy implementation

First, Chinese economic data are always published on time, but the frequency of publication of key data sets (i.e. quarterly data on GDP by expenditure) and their quality, i.e. in the “new service economy” and the shadow banking activities, show need of improvement. Often Chinese statistics draw an inconsistent picture of the economy with some data (i.e. energy imports) suggesting a more favorable development of domestic demand than other data such as transport volumes, credit growth or electricity consumption. A number of domestic high-quality economic research institutes could play an important role. It would be necessary to strengthen the autonomy of these think tanks and to allow them to scrutinize official data and publish their own research free of interventions and in a competitive environment.

Second, economists often refer to the “impossible trinity” dilemma, according to which it is only possible to achieve two out of the following three targets at the same time: autonomous monetary policy, exchange rate stability and free capital movement. Striving for exchange rate stability (China pursued this course after August 2015 when it sold foreign exchange to mitigate depreciation) and allowing for freer capital movement has come at a price for the autonomy of China’s monetary policy. Under the current conditions, China should allow more flexibility of the exchange rate while controlling the speed of exchange rate movements by maintaining certain controls on the free flow of capital.

Third, the lack of transparency and communication are serious shortcomings of China’s monetary policy. There has to be a clear separation between the tasks of China’s Central Bank and government and Party authorities. In order to prevent market uncertainty, the Central Bank should hold regular meetings and communicate decisions to investors and the public via user-friendly channels.

Consistent policies increase resilience

Finally, China’s authorities deciding on the allocation of financial resources are still more likely to opt for bureaucratic interventions rather than respond to market signals. This goes back to a misdirected system of incentives. For example, civil servants are often remunerated for initiating prestigious infrastructure projects regardless of their economic cost or environmental impact. China needs to set up independent impact assessment agencies to evaluate public spending and to hold agencies and civil servants accountable for grave and obvious misallocations.

For its own good, China will need clear and consistent economic policies to increase the resilience of its real economy and financial system against unexpected shocks. But Chinese policymakers are no longer responsible for their own country alone. As much as they disliked being caught by surprise when the US financial system went off the rails in 2008, they should be aware that the rest of the world is anxiously looking to China as a potential new source for global economic turmoil.