Via Wei Yao of Societe Generale, ...and what it means for the rest of the world
Following on from our earlier discussion of how a Chinese hard landing would evolve, SocGen now examines how a Chinese hard landing would impact the global economy. They see the contagion in several ways: mechanically (since China is part of the global economy) and through trade, financial and market channels. Mechanically, a slump in Chinese GDP growth to just 3% would cut our global GDP growth forecast by 0.6pp. Add to that the channels of transmission to the global economy, and our expectation is that a Chinese hard landing would result in 1.5pp being slashed from global GDP growth in the first year.
How important is China as a source of global demand?
With imports equivalent to 30% of its GDP, China is a major source of global demand. Exports to China as a percentage of GDP are largest in Asia and amongst the commodity exporters, so these countries would be hardest hit. Drawing on different studies, mainly from the IMF and the OECD, we estimate that the impact of the trade channel from the type of hard landing in China described in the previous section would cut GDP growth by around 4.5pp in Taiwan, 2.5pp in South Korea and Malaysia, 1.2pp in Australia, 0.6pp in Japan, 0.3pp in the euro area and 0.2pp in the US. For the global economy ex-China, the trade channel effects would bring about a reduction of around 0.7pp to GDP growth.
The impact of a Chinese hard landing on the rest of the world could be aggravated by the fact that investment would be particularly hard hit. As noted in the previous section, we expect investment – which now makes up half of Chinese GDP – to fall more than consumption if China does suffer a hard landing. And investment has significantly higher import content than consumption, most notably through commodities and machine tools. This could have a particularly sharp impact on some smaller commodity producers. For example, exports of energy and metals to China make up over 40% of Mongolia’s GDP. In terms of capital good exports to China, Taiwan has the closest ties, depending for just under 15% of its GDP thereon; but this is already a much lower number than that of Mongolia and many of the other commodity exporters. Exporters of consumer goods are less exposed, as seen in the chart overleaf.
For all the talk of the importance of China to exporters such as Germany, the absolute numbers remain modest despite strong growth in recent years.
Would currency and trade wars result?
The decline in global trade that would come with a China hard landing naturally leads to the question of whether currency and trade wars would result. As outlined by Wei Yao in the previous section, our scenario assumes Chinese policymakers would tread very carefully, being only too well aware of the dangers. In Washington, the appreciation of the dollar that would follow as investors (both new foreign investment and US repatriation from abroad) seek the safety of US shores would not be welcome. Moreover, the Chinese yuan would be far from the only currency depreciating against the US dollar; trade weighted, our China hard landing scenario assumes a 10% dollar appreciation in the first year and this despite additional QE from the Fed. It does not take any great stretch of the imagination to paint an even bleaker scenario in which a China hard landing triggers outright currency wars and protectionist measures on trade flows. This would further aggravate the negative impact of a China hard landing and extend the duration of the shock.
How important are financial links to China?
Of the total foreign claims of BIS-reporting banks as of June 2012, only $731bn – or just 2.4% of the total – are on China. The risk of China transmitting a hard landing to the rest of the world through the banking channel thus appears modest. Foreign corporations present in China would see the value of their investments decline, but more importantly, profits generated in China would slump, hitting several major multinational companies. The response would be cost cutting, and not just in China.
Does the starting point for the global economy matter?
Our what-if analysis of a China hard landing draws on a wide body of academic research that analyses various shocks and how these disseminate to the global economy. These analyses often implicitly assume the starting point of an economy in equilibrium and with a well stocked arsenal of policy ammunition. The current situation is very different, however, with large output gaps in many of the world’s major economies, ongoing headwinds from deleveraging and policy arsenals already depleted. Add a China hard landing to the mix, and we expect the result would be a far greater uncertainty shock than had the starting point been a world in overall good health. Uncertainty would cause corporations globally to hold back further on investment and hiring decisions (even those not directly exposed to China). And, feedback loops from financial channels would further amplify the uncertainty shock as risky asset prices collapse. At the global level, we estimate that the combined uncertainty shock in our China hard landing scenario could exceed 1% of global GDP.
Where could offsets come from?
The effects of a Chinese hard landing on growth could, however, be offset by some secondary effects. Lower commodity prices are perhaps the most important. As a rule of thumb, we assume that, all else being equal, a $10/b permanent drop in the oil price would boost global GDP by around 0.3pp. Our commodity strategists’ assumption that a Chinese hard landing would initially cut oil prices by 30% implying a first offset.
The greater hope for offset is policy. Central bankers are usually the first at the scene of any shock and a first response would likely be more QE from the Federal Reserve, Bank of Japan and Bank of England. However, several prominent central bankers have already noted that there is a limit to QE and that it comes with diminishing returns. The ECB would keep the promise of OMT (Outright Monetary Transactions under the conditionality of a European Stability Mechanism programme) on the table and continue to supply amply liquidity. Central bankers could also explore other possibilities. The BoE already has a funding for lending scheme, the BoJ buys ETFs and REITs, Danmarks Nationalbank has a negative deposit rate … none of these measures have to date proven a panacea, however. This would not prevent central banks from trying, but we remain doubtful it would work and also note that some measures would require changes to legislation (such as the Fed buying equities) and would thus not be a day one response option. Turning to fiscal policy, we believe most advanced economies have little room for manoeuvre, though the US and Germany are potential exceptions; but even here we would not look for aggressive steps measures.
By contrast, emerging economies have greater room for both fiscal and monetary policy stimulus. If China does experience a hard landing however, some of the foreign inflows attracted by the higher returns in these markets could reverse, adding to pressure on these economies (albeit with the silver lining of currency depreciation).
Overall, we see little scope for economic policy to significantly offset the negative effect of a Chinese hard landing on the global economy. Additional policy stimulus would mainly serve to limit negative tail risks.