In the game of musical chairs that China’s economic policy is, reflation is now chair-less. Stability and tough love have found chairs. It is having repercussions on the rest of the world. Industrial metals are slumping. So has the price of gold recently. Of course, the latter could be due to the financial markets being able to look past any cloud—heavy or dark or both. The Morgan Stanley Capital International China Investable Market Index is up a respectable 15.2% in the first four months of the year in US dollar terms. But the Shanghai Composite Index tells a different story. The index had gained 6% year-to-date until the first 10 days of April. Now, it is barely unchanged for the year. So, it has lost 6% in the last few weeks. The Wall Street Journal published an article on Friday with four charts—all of them painting a dramatically dire picture of China’s financial assets: stocks in decline, bond yields rising, defaults picking up and overnight interest rates up. The problem is that we have seen this movie before. There is no need to get excited. It is not the end of the China story. Nor is it a story of China grabbing the reform bull by its horns. As Victor Shih at the University of California (San Diego) said, the day China truly deleverages would be the day a new financial crisis dawns.

China retains the ability to turn the tap off and on and the rest of the world, particularly the US, is unwilling to or afraid of letting China fail. China is too big to fail. The China economic story has been brittle and fragile for quite some time now. But it has not collapsed. The reason is that the financial market participants do not want to believe and act accordingly. If they did so, the game would have been up long ago. They are acting in rational self-interest. If China went under, so would many of them. The US economy is not even remotely strong enough to withstand the short-term impact of a China economic collapse, as it would ripple through almost every market—from financial assets to commodities to interbank lending to insurance.

The new administration in the US was expected to play hardball with China, reinforcing a monetary policy tightening cycle. The former would turn the screws on China’s currency even as the latter precipitated capital outflows from China. First, the moment the American President’s grandchildren sang songs in Mandarin to the visiting Chinese President, we knew that the script had changed. Second, the Federal Reserve is normalizing interest rates too slowly and it was too late to begin doing so in any case. Even more frustrating is that critics of the Federal Reserve monetary policy framework are arguing that the Fed is now committing a mistake by hiking interest rates since the inflation rate in the US is non-threatening. Instead, they should be urging the Federal Reserve to abandon its flawed framework and assign a weighty role for asset prices or financial stability. Instead, between the protagonist and the critic, one muddle meets the other. Hence, even as the resolve of the Federal Reserve to tighten remains a question mark, the critics are not steeling it. Unfortunate. The gradual and careful Federal Reserve is unlikely to tip the Chinese economy into a free fall.

On its own, China is unlikely to allow the current squeeze on liquidity to continue further to the point where it would bring the Ponzi scheme—the Chinese economy—down. It is a holding operation, after having allowed loans and liquidity to flow liberally in the first quarter. Liquidity and loans will be flowing freely again, well before it is time for the National People’s Congress in October. Indeed, it will be logical for speculators to consider the recent decline in industrial metals and crude as short-term buying opportunities.

Those who are looking at developments in Anbang Insurance in China as a proxy for the system’s fragility are likely to be disappointed. Anbang was a sub-Ponzi scheme. It had used insurance premiums to buy long-duration illiquid assets overseas. The company was useful in growing the empire. It had promised high returns to clients who bought the financial products it conjured up. It appears that the company had outlived its purpose. The head of the insurance regulatory authority was dismissed. The new head has banned the company from marketing new products and an influential magazine wrote a story on how the company’s capital raising a few years ago might have been fake. This is a rearrangement of power brokers. Predicting the system’s demise based on these is difficult even if it is not wrong.

Finally, China has staunched capital outflows with draconian (surprise, surprise) controls. Hence, the decline in foreign exchange reserves has been arrested for now. Axiom Capital (through estimates that available foreign exchange reserves, after netting out commitments, is not $3 trillion but a more modest $1.7 trillion—well below the estimated safety threshold of $2.6 trillion. All these matter only if speculators are willing to test the Chinese government and the central bank. They are not ready to do so. Not in sufficient strength.

China bears have to wait for hubris-driven political and power over-reach, resulting in disastrous decisions that topple the applecart. Alternatively, wait for a meteor strike that brings down the houses of cards globally, including the US stock market.

V. Anantha Nageswaran is the co-author of  The Economics Of Derivatives and Can India Grow? Read Anantha’s Mint columns at

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