China Has Taken Out an Insurance Policy, Not a Bazooka

With many having characterized China as “uninvestible” just a few months ago, investors’ enthusiastic response in recent weeks to a perceived shift in the authorities’ policy reaction function is also likely to be an overreaction. It grossly oversimplifies the competing priorities of a country with internal imbalances, inefficient resource allocation channels, and exposure to further geopolitical tensions.

“Buy everything China” is how one investor argued should be the markets’ reply to signs out of Beijing that the leadership was more open to adopting major stimulus measures. The value of Chinese stocks soared by almost 40% in 10 trading days. Massive inflows of foreign investor funds suddenly replaced what had been persistent and cumulatively large outflows for well over a year.

Judging from history, investors had good reasons to exchange their protracted caution for a sudden bout of exuberance. If finally willing, China has the ability to deploy a “bazooka” type of policy response centered on large fiscal stimulus which, judging from the experience of the Global Financial Crisis, promises to have a meaningful effect on the economy. The resulting market moves would be seriously augmented by portfolio positioning which had foreign investors significantly underweight Chinese exposures relative to their benchmark.

As compelling as this seems, it runs against China’s economic logic.