China: The slowdown and its global impact Global Economic Outlook, Q4 2015

China has been front and center in the world’s financial news lately—with plummeting equity prices, a slowing economy, and policy-directed currency depreciation. What is the reality of China’s slowdown and its potential impact on the world?

China has been at the center of commentary about the global economy recently. The severe drop in Chinese equity prices, the continuing news about China’s slowing economy, the country’s decision to allow the currency to depreciate, and the widespread impression that China’s economic woes are behind the recent sharp drop in global equity prices have all been front and center in the pages of the world’s financial press. Let us consider how accurate the commentary is.


Measuring the slowdown

First, the economy is indeed slowing. In both the first and second quarters, real GDP was up 7.0 percent from a year earlier—the slowest rate of growth since 2009. In addition, for the past few months, industrial production has been rising at a low rate not seen since 2009. Moreover, many observers are convinced that the economy is actually growing more slowly than the official numbers suggest. They observe that freight rail traffic is down from a year earlier and that electricity generation is growing very slowly. These and other data suggest a deeper deceleration of economic activity than the government is reporting. On the other hand, although manufacturing and construction have decelerated, the services sector in China continues to exhibit strength. Thus while the slowdown might not be as severe as some people fear, there is no doubt that the economy has slowed.

What is the source of the trouble? There are two key problems. First, there is excess capacity in heavy industry and property, both of which have seen debt-fueled investment booms in recent years. It should be no surprise, then, that investment spending has substantially decelerated, especially for property construction. Investment funded by foreigners has actually declined. Second, exports have declined. This is due, in part, to weak global demand. In addition, as the Chinese renminbi has remained fairly steady in value against the US dollar, the dollar’s rise has sent the renminbi soaring against the euro and the Japanese yen. The result has been a loss of competitiveness of Chinese exports to Europe and Japan. Thus it is no wonder that exports have declined, contributing to the weakness of the industrial sector.

The policy response

The principal policy response to economic weakness has been to ease monetary policy. This has entailed cuts to benchmark interest rates as well as a reduction in banks’ required reserve ratios, with the latter boosting the supply of funds available for lending. The goal of such a policy is to boost credit market activity and, as a consequence, investment. The result has been that bank lending was up 14.4 percent in July versus a year earlier, the fastest rate of growth since late 2013. Yet investment in fixed assets continues to decelerate. Rather, the increased credit has allowed highly indebted businesses (especially property developers) to roll over existing debts. In addition, the increase in credit contributed to the equity price bubble that reached its peak in June. Millions of households took on margin debt in order to purchase equities, only to see equity prices plummet over the course of the summer. The government intervened in the equity market in a variety of ways, the effect of which has been to stem the downward tide. As of this writing, equity prices are down around 40 percent from their peak but remain about 50 percent higher than in early 2014.

A debate is emerging about the possible consequences of a bursting of China’s frothy equity market bubble­—if and when it eventually comes.

The global impact

In August, global equity prices, including Chinese prices, suddenly plummeted following news that China’s manufacturing sector was weaker than many analysts had expected. Some analysts blamed the global rout on the collapse of China’s equity market. Others suggested that concerns about China’s slowdown, and its potential impact on the rest of the world, were the proximate cause. Some even worried that China might be headed for a recession. Are any of these the real reasons for the plummet?

First, it is increasingly apparent that the Chinese equity market is uncoupled from the state of the larger economy. The market soared when it was clear that China was slowing, and it plummeted following similar information. China’s equity market is not well integrated into the global economy, nor does it play a major role in financing Chinese investment or as a source of wealth for Chinese households. Thus it is unlikely that the drop in Chinese equity prices can be blamed for events in the rest of the world.

China_2Second, China’s slowdown does have an impact on the rest of the world, but that impact is unevenly distributed. The slowdown in fixed asset investment has caused a drop in commodity prices, thus hurting exporters such as Australia and Brazil. The drop in manufacturing activity and trade has hurt East Asian countries that are integrated into China’s manufacturing supply chain, including South Korea, Taiwan, and several countries in Southeast Asia. The impact of China’s slowdown on the United States and Europe, however, is likely to be more muted. Although China is the third-largest export market for both the United States and Europe, even a sizable drop in exports to China would be expected to cut US or European GDP growth by only a few tenths of a percentage point.

Third, although China’s economy has slowed, it appears unlikely to head toward a recession. There remain considerable pockets of strength in the economy, including the consumer sector, which is expanding at a healthy pace. Of course, a prolonged slowdown is possible, the duration of which will depend on the mix of policy that the government implements. Policies aimed at boosting consumer demand rather than investment are more likely to create conditions for sustainable acceleration in growth.

Finally, the sudden drop in global equity prices in August was probably fueled by news about China. But the reality is that there had already been considerable commentary about overvaluation and how markets were overdue for normal corrections. Companies with significant exposure to the Chinese market will face consequences from the Chinese slowdown. However, the overall European and US equity markets are likely to be mostly influenced by expectations about local market earnings and interest rates.

Of currencies and capital flows

There has been much talk about capital flowing out of China; one might wonder what exactly this entails. Here is a brief primer on currencies, capital flows, and what has been happening in China.

Consider how China obtains dollars. A simple example might involve a Chinese factory that uses local cotton and local labor to make T-shirts that are then sold to a big American retailer in exchange for US dollars. The company deposits those dollars in a Chinese bank. Then the bank might sell them to a local retailer who uses the dollars to purchase DVDs from a Hollywood studio to sell them to Chinese consumers. Essentially, the dollars have traveled back and forth, and T-shirts have effectively been traded for DVDs. Alternatively, the bank might sell the dollars to a wealthy Chinese individual who uses them to purchase a condo in Manhattan. This is a capital outflow: Again, the dollars have traveled back and forth, but now Americans have obtained T-shirts in exchange for someone in China owning a nice apartment in New York.

As for the wealthy Chinese individual, he or she has exchanged assets held in China for an asset held in the United States—thus his or her capital has flowed out of China. If China runs a trade surplus (exports exceed imports), which it has done for decades, it makes sense for the excess dollars that China accumulates to be used by Chinese to accumulate US assets. Yet, until a few years ago, China not only ran trade surpluses, it also had almost no capital outflows. Instead, it had net inflows of capital. As such, there was an excess supply of dollars, or excess demand for renminbi. Normally, this would lead to an increase in the value of the renminbi, or a currency appreciation. Yet the Chinese government did not want that to happen, at least not too rapidly. So it massively purchased dollars in order to supply the market with the highly sought-after renminbi. That is why China’s central bank accumulated such a huge amount of dollars: nearly $4 trillion.

As China sells dollars, the question has arisen of how China’s large-scale selling of US Treasury securities will affect bond yields in the United States.

Lately, however, things have changed—dramatically. Chinese have started seeking overseas assets in a big way. This partly reflects the government’s financial liberalization, but it also reflects the pessimism and worry of some wealthy Chinese who are eager to park their funds overseas. So lately the demand for dollars needed to buy foreign assets has actually exceeded the supply generated by selling those T-shirts. Normally this would lead to an increase in the value of the dollar or a decrease in the value of the renminbi, yet China’s authorities have been reluctant to let the renminbi fall too quickly. Consequently, they have been selling dollars in order to meet the demand for dollars. In the last two years, capital outflows from China have amounted to hundreds of billions of dollars. The central bank has sold about $350 billion in reserves. And although the central bank did recently allow a small currency depreciation, it quickly resumed intervention to prevent the currency from falling too much.

China_3What happens next? If the central bank continues to sell dollars in order to maintain the exchange rate, Chinese investors will logically anticipate an eventual depreciation of the currency. This will lead them to demand more dollars in order to buy more condos in New York. Eventually, the central bank will run out of dollars and will let the currency fall. Chinese with condos in New York will then see a sizable capital gain. It would mean lower prices of exported Chinese goods, which means China would essentially be exporting deflation to the rest of the world. China’s capital markets would become integrated into the global system. Foreign investors would seek bargains in China, and capital would eventually start to flow back into China, thereby putting upward pressure on the value of the renminbi. The problem is that the transition from today’s situation to that eventuality could be a wrenching process.

Meanwhile, as China sells dollars, the question has arisen of how China’s large-scale selling of US Treasury securities will affect bond yields in the United States. Could China disrupt US financial markets in the process? The answer is probably not. When the US Federal Reserve stopped massive purchases of Treasury securities last year, bond yields didn’t move much. China already selling plenty of such securities in the past year does not appear to have influenced pricing. Moreover, if China started selling Treasuries in larger amounts, it would likely cause investors elsewhere to engage in a flight to the safety of US Treasuries. This is, of course, what usually happens when there is new uncertainty or volatility in the world. Finally, the reality is that the secondary market for US Treasuries is so large and liquid that it would take a massive sale in order to move that market. This seems highly unlikely and would probably only happen if China were in the midst of economic collapse—in which case, there would be the same flight to safety. As such, there appears to be no need to lose sleep over US Treasury yields.