Why China is right to be wary

I was reading Richard Bookstaber's A Demon Of Our Own Design over the holidays, which looks, among other things, at the history of financial product innovation. It reminded me again of how relevant past crises are to today's markets.

Three incidents in particular, and the lessons taken from them, are very useful in understanding some of the more worrying stories about China.

You may remember a couple of recent spats involving big state-controlled Chinese companies refusing to honour derivatives contracts they had signed with Western firms. There was a lot of grumbling about China not playing by the rules and damaging its appeal to foreign businesses. That may be true (although probably not in finance, where investors seem to have staggeringly short memories).

Try 6 free issues of MoneyWeek today

Get unparalleled financial insight, analysis and expert opinion you can profit from.

Start your trial

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

But as the Chinese authorities know, Western banks ruthlessly took advantage of the naivety of Japanese banks and companies as the country's bubble peaked in the zaitech (financial engineering) craze. You can see these defaults as a warning that China won't tolerate similar funny business.

Then there's the Plaza Accord of 1985 and its aftermath. Back in the early 1980s we had a weak yen and strong dollar, favouring Japanese exporters over American firms. So Japan and the US, plus Britain, France and Germany, agreed to weaken the dollar versus the yen. Over the next two years, it fell by 50%, until the slide was brought to a halt with the Louvre Accord in 1987.

Many analysts have blamed the shock this caused to Japanese manufacturing and the loose monetary policies that Japan then adopted to combat that, for creating the bubble. Understandably, China is not keen for the same to happen, hence its refusal to revalue the renminbi faster in spite of complaints from America.

Finally, there's Russia and its shock-therapy approach to changing from communism to a form of free-market democracy that saw the economy and society fall apart in the early nineties. Many have argued that it had no other choice. Regardless, China undoubtedly sees Russia's fate as a salutary lesson in changing too much, too quickly.