A new Chinese export-recession risk

Updated September 21, 2015

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An employee works at an assembly line of China CNR in Tangshan, Hebei province, in this file photo. A unit of China’s CRRC Corp, the world’s biggest train-maker by revenue, last week broke ground on a factory in the US which will manufacture trains for Boston’s subway system as part of a $556m deal that the unit won a year ago.—Reuters
An employee works at an assembly line of China CNR in Tangshan, Hebei province, in this file photo. A unit of China’s CRRC Corp, the world’s biggest train-maker by revenue, last week broke ground on a factory in the US which will manufacture trains for Boston’s subway system as part of a $556m deal that the unit won a year ago.—Reuters

IS a global economic recession likely? If so, what might trigger it? Willem Buiter, Citi’s chief economist and the Financial Times’ erstwhile Maverecon blogger, answers these questions: ‘Yes’ and ‘China’. His case is plausible. This does not mean we must expect a recession. But people should see such a scenario as plausible.

Mr Buiter does not expect world output to decline. The notion here is a ‘growth recession’, a period of growth well below the potential rate of about 3pc. One might imagine 2pc or less. Mr Buiter estimates the likelihood of such an outcome at 40pc.

His scenario would start with China. Like many others, he believes China’s growth is overstated by official statistics and may be as low as 4pc. This is plausible, if not universally accepted.

It might become even worse. First, an investment share of 46pc of gross domestic product would be excessive in an economy growing 7pc, let alone one growing at 4pc. Second, a huge expansion of debt, often of doubtful quality, has accompanied this excessive investment. Yet merely sustaining investment at these levels would require far more borrowing. Finally, the central government, alone possessed of a strong balance sheet, might be reluctant to offset a slowdown in investment, while the shares of households in national income and consumption in GDP are too low to do so.


The world economy will remain vulnerable to adversity until China has completed its transition to a more balanced pattern of growth and the high-income economies have recovered from their crises


Suppose, then, that investment shrank drastically as demand and balance-sheet constraints bit. What might be the effects on the world economy?

One channel would be a decline in the import of capital goods. Since about a third of global investment (at market prices) occurs inside China, the impact could be large. Japan, South Korea and Germany would be adversely affected.

A more important channel is commodity trade. Commodity prices have fallen but are still far from low by historical standards. Even with prices where they are, commodity exporters are suffering. Among them are countries like Australia, Brazil, Canada, the Gulf states, Kazakhstan, Russia and Venezuela. Meanwhile, net commodity importers, such as India and most European countries, are gaining.

Shocks to trade interact with finance. Many adversely affected companies are highly indebted. The resulting financial stresses force cutbacks in borrowing and spending upon them, directly weakening economies. Changes in financial conditions exacerbate such pressures. Among the most important are movements in interest and exchange rates and shifts in the perceived soundness of borrowers, including sovereigns. Changes in capital flows and risk premia and shifts in the policies of important central banks exacerbate the stresses. At present, the most important shift would be a decision by the US Federal Reserve to raise interest rates.

As Warren Buffett said, “you only find out who is swimming naked when the tide goes out”. According to the Bank of International Settlements, credit to non-bank borrowers outside the US totalled $9.6tn at the end of March. A strong dollar makes any currency mismatches costly. These may start on the balance sheets of non-financial corporations. But the impact will be transmitted via their losses to banks and governments. Thus, reversal of ‘carry trades’, funded by cheap borrowing, might wreak havoc.

A visible shift is a decline in foreign exchange reserves, driven by deteriorating terms of trade, capital flight and withdrawal of previous capital inflows. This might cause ‘quantitative tightening’, as central banks sell holdings of longer-dated safe bonds. This is one of the ways that these shocks might be transmitted to the high-income countries, including even the US. But this also depends on what the holders of the withdrawn funds do with it and on the policies of affected central banks.

What we might see, then, is a series of real and financial linkages: declining investment and output in China; weaknesses in economies dependent on that country’s purchases or on prices set by its buying; and reversals of carry trades and shifts in exchange rates and risk premia that stress balance sheets.

How might policymakers respond? China will surely let its currency fall rather than continue to lose reserves, not least because usable reserves are smaller than headline numbers, which include infrastructure investments in Africa and elsewhere that cannot be sold quickly. The policy space of other emerging economies is greater than in the past, but not unlimited. They will be forced to adjust to these shocks rather than resist them.

Meanwhile, the policy choices of high-income countries are restricted: politics has almost universally ruled out fiscal expansion; the intervention rates of central banks are near zero; and, in many high-income economies, private leverage is still quite high. If the slowdown were modest, nothing much might be done. The best response to a big slowdown might be ‘helicopter money’, created by the central bank to stimulate spending. But its use seems quite unlikely. The conventional rules.

In brief, a global growth-recession scenario ‘made in China’ is perfectly plausible. If it were to happen, a decision by the Fed to tighten now would come to look downright foolish. We are not talking about the sort of disaster that accompanies a global financial crisis. But the world economy will remain vulnerable to adversity until China has completed its transition to a more balanced pattern of growth, and the high-income economies have recovered from their crises. That is still far away.

martin.wolf@ft.com

Published in Dawn, Business & Finance weekly, September 21st, 2015

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