9th July 2015
Jeremy Lawson Chief Economist Standard Life Investments looks at what exactly is happening in China and what other countries might be most affected by the slowdown or a hard landing.
With Europe finally recovering after years of sub-par growth, the biggest threat to the global economy is arguably China. Real GDP growth moderated to an annualised rate of just 5.8% in the first quarter, which dragged year-on-year growth down to 7.0%. Both were the weakest outcomes since the global financial crisis.
While real growth has slowed significantly in recent years, the deterioration in nominal activity has been even more dramatic. As late as the middle of 2011, nominal GDP was growing at an annual rate of 19%; in the most recent quarter nominal growth was just 5.2%, with growth in the GDP deflator slipping into negative territory.
This economy-wide disinflation, and more recently deflation, has mostly been due to rapidly declining commodity prices, though non-commodity consumer price inflation has also slowed. To get a more detailed picture of what is driving China’s growth slowdown, it is necessary look at a broader array of economic and financial indicators than simply the aggregate GDP figures. The epicentres of the economy’s problems are the industrial and property sectors. Growth in real industrial output has declined from 14% in mid-2011 to 5.9% in April, growth in fixed-asset investment has halved over the same period and electricity consumption by primary and secondary industries is in outright decline.
China’s trade with the outside world is also falling, though one has to interpret this data with care because it does not always match up with other countries’ trade statistics. Meanwhile, real estate investment, which had been the primary engine of growth up until last year, is going through a prolonged slump.
The two main components of activity preventing a deeper downturn in activity are private spending on services, particularly financial services, and government-led increases in transportation infrastructure. Retail sales, especially e-commerce sales, have been growing faster than the overall economy, and electricity consumption in the services sector is also expanding strongly. Meanwhile, growth in household incomes is now outpacing GDP growth. All this suggests that China has begun the necessary rebalancing towards a more sustainable, consumption-led growth model, although it is still too early to claim success.
Some moderation of growth and rebalancing away from investment was intended by the authorities.
Excess investment by property developers, encouraged by local governments focused more on the quantity than the quality of growth, had led to a significant oversupply of residential property and fuelled a dangerous build-up in leverage. State-owned enterprises had also joined this debt-driven party, leaving the heavy industrial sector with excess capacity and weak profits. Recognising these problems, the government has been stepping up the pace of structural reforms, including cracking down on corruption and liberalising the financial system. Monetary and fiscal policy is also being loosened but in a targeted way, managing the slowdown in growth and credit, rather than as a strong supporting impulse for the economy.
That measured approach to policy appears to have been cast aside more recently as the deterioration in economic activity has been too rapid for the authorities liking.
Beijing has partially reversed its decision to limit Local Government Finance Vehicle (LGFV) lending, infrastructure spending is being ramped up, and further cuts to reserve requirement ratios and lending rates are in the offing. The aim is to push growth towards the government’s target by continuing government support for directed credit before moving back towards more market-driven lending once current worries have abated. We expect the government to have some modest success in boosting GDP in the near term, though the long term glide path is still down and most of the risks remain to the downside.
Although it is not our baseline expectation, a hard landing in China would obviously be a large negative shock for the global economy, representing as it does 12% of global GDP at market exchange rates and some 18% of global manufacturing exports. It has also been the dominant source of demand for global metal commodities and, according to the IMF, it has accounted for more than a third of global growth over the past seven years. Those figures provide a clue as to which countries stand to lose the most from any failure of the Chinese authorities to stabilise growth: commodity and manufacturing intensive economies that are closely integrated with the Chinese property and industrial sectors.
On the commodity front, countries like Australia, Brazil, Canada, Chile and Peru stand out. In terms of manufacturing, it is Hong Kong, Korea, Malaysia, Singapore and Taiwan that are most exposed, while several important developed economies like Germany export a sizeable amount of capital goods to China. Navigating China’s slowdown is of course only one of the challenges facing the emerging market (EM) complex. Even excluding the Chinese figures, aggregate EM GDP is growing at its slowest pace since the crisis, partly because two of the largest economies – Brazil and Russia – are both in recession.
Productivity growth is also exceptionally weak, largely due to widespread failures to undertake domestic reforms. Slow growth and moderating inflation explains why many emerging economies have been loosening monetary policy in recent months. For the most part, this easing has been justified but for economies like Turkey, that still have large external imbalances, there is a danger in taking things too far at a time when most of the downward pressure on inflation from global sources is waning and the Fed is getting closer to raising its own benchmark interest rates. There is good news. Our research shows that that most emerging markets are in a much better position to withstand external shocks than they were in the 1990s, thanks to improved fiscal and monetary policy frameworks.
One example is much greater willingness by most countries to allow their currencies to depreciate in the face of external shocks. Moreover, there are a number of positive growth stories to report. Eastern European members of the European Union, such as the Czech Republic, Hungary and Poland, are clearly benefiting from the turnaround in the Eurozone’s growth prospects, while Indian growth is being propelled forward by lower energy prices, improved reform momentum and accommodative monetary policy.