We discuss whether China is becoming less exposed to global growth and trade, before assessing how exposed the rest of the world is to an economic shock in China.
China’s importance to the global economy cannot be overstated. China is the second largest economy in the world, but it is once again expected to be the largest contributor to global GDP growth. On IMF forecasts, China will contribute over 30% to global GDP growth this year, comfortably exceeding that of the US, the EU and Japan combined.
Less well known is the fact that its rapidly expanding financial sector is also amongst the largest in the world. Indeed, China accounts for 13% of global financial assets, placing the country second behind the US. Shocks to the Chinese economy that emanate from both trade and non-trade channels therefore have the potential to reverberate around the world in much the same way as turbulence in the global economy can impact China.
It is clear that as China rebalances away from import-intensive investment spending to consumer spending and from an export-oriented manufacturing sector to services, both exports and imports will become less important for the economy. But is the economy becoming less reliant on global growth and trade? The answer is yes, if one restricts the narrative to the narrow prism of visible trade, but the recent mini China-focused crisis reminds us that China and the global economy are becoming increasingly intertwined through the financial markets channel.
The disconnect hypothesis
At the height of the Global Financial Crisis, China stepped in with a 4 trillion Yuan fiscal stimulus package equivalent to 12% of GDP. This package was mainly spent in 2009/10 on a range of infrastructure projects. Consequently, China was the primary source of global economic growth during these years, and has continued to dominate ever since. It is no exaggeration to suggest that global growth is in fact ‘made in China’1. Put another way, it is almost impossible to think of global GDP growth without carefully considering the role of China.
fiscal stimulus in China was financed by debt that was routed through
off-balance sheet financing vehicles on behalf of local government. The size of
the stimulus and the institutional arrangements that were in place for
identifying and implementing these projects has led many researchers to
question the efficiency of capital allocation2. Recent IMF research suggests that the
capital-output ratio – a measure of the efficiency of investment – has risen
from around 4 in the six years leading up to the Global Financial Crisis to 6
in the period since3. That is to say, China requires 50% more
capital to produce the same additional unit of output. As returns on capital
came under pressure, the stimulus surge faded and investment spending in China
slowed from around 9% in 2013 to 6-7% in 2014 and 2015.
There were two important consequences of that deceleration in investment. Firstly, GDP growth slowed from 7.8% in 2013 to 6.9% in 2015. Secondly, Chinese import growth slowed significantly over this period. According to IMF research, around 40-50% of the slowdown can be attributed to the weakness in investment. Weaker exports account for most of the rest of the slowdown in imports and that in turn is attributable to the stronger RMB.
China: exports and imports as a % of GDP
At first glance this suggests that global trade dynamics are becoming less important for China, especially since Chinese export and import volume growth has slowed as the country transitions away from investment and towards consumer spending. China is at an early stage in that process and there is every reason to believe that import volume growth may well slow further. In that regard, it is correct to suggest that Chinese GDP is becoming less reliant on global trade, but that the adjustment is likely to be slow for a number of reasons, including the fact that the Chinese export sector will reform and seek new opportunities by climbing the technology ladder.
Notwithstanding these trade statistics, the relationship with the US remains as important as ever. The share of US goods and services imports from China continues to rise (see chart below). A quick glance at the trade data for 2015 also shows that the manufacturing sector deficit with China has widened once again, so much so that over the past 2 years that deficit has grown by 15%, or $47bn. What’s more, the US alone accounts for some 60% of China’s total manufacturing surplus4. Unsurprisingly, prospects for Chinese exports remain heavily dependent on US domestic demand (see chart below) with a growth correlation of 70%.
US imports from China (% of total imports)
China exports to US and US domestic demand (y/y)
The data also show that the Chinese manufacturing sector has become less important for the economy – a consequence of rebalancing – but at close to 30% of GDP, the sector remains among the largest in the world, both in absolute terms and also as a share of GDP.
Manufacturing sector (% of GDP): Emerging
Manufacturing sector (% of GDP): Developed
Given the size of China’s economy and its financial sector it is only fair to conclude that China and rest of the world have a symbiotic relationship, with the obvious corollary that a real or financial sector shock that emanates from China will have material consequences for the global economy.
The most recent crisis served to remind us that a country such as China with many strong macroeconomic fundamentals – a large and persistent current account surplus, rapid economic growth, a colossal stockpile of foreign exchange reserves, a low stock of sovereign debt and a small fiscal deficit – is vulnerable too. China, in fact, has lost some 20% of its foreign exchange reserves since mid-2014 as fears of a renminbi devaluation encouraged capital outflows and a sharp drop in inflows (see chart below). This occurred despite the fact that the country imposes restrictions on the capital account, proving once again that capital controls are a porous form of defence.
The IMF has argued that China’s stockpile of reserves is at a comfortable level for the size of its exports, its stock of debt and broad money, its fixed exchange rate regime and its capital controls. That may well be the case, but looking ahead, as China eases its capital controls, it will also have to allow greater exchange rate flexibility, otherwise it runs the risk of a run on its currency and another dramatic drop in reserve balances.
The underlying factors that triggered the mini-crisis have not disappeared. To be sure, the currency is more realistically valued, but China remains imbalanced and addicted to credit-fuelled growth. Analysis by the IMF shows that the credit intensity of GDP growth has risen dramatically from slightly above 1 unit of new credit per unit of GDP in the pre-Global Financial Crisis period to just below 3 in the period since. As discussed above, returns on investment have fallen sharply in recent years. Chinese economic growth must slow and returns on capital employed will likely continue to fall.
The carry trade is one source of risk that became obvious recently, but there are others. Countries such as China that have experienced such a rapid expansion of credit have typically suffered banking crises and a significant slowdown in economic growth. A slowdown of growth of 4% is not uncommon in these circumstances and there is little reason to believe that China would be an exception.
A full-blown crisis in China that subtracts this amount of GDP growth for a prolonged period of time will have a profound impact on global activity. Recent research shows that a permanent 1% negative shock to Chinese GDP growth could remove 0.23% from world output, implying that a full-blown banking crisis in China could subtract around 1% from global growth. Unsurprisingly, the results show that Asian countries such as Malaysia, Singapore, Indonesia and Thailand are the most vulnerable, but activity in the Euro Area and the US is also at risk.
China foreign exchange reserves and the exchange rate
Vix: China ETF and S&P 500 (y/y change)
The shock need not emanate from China. Readers will recall that fears over the US Fed tapering its QE stimulus programme in 2013 had a disproportionately negative impact on the emerging world. And recall more recently the capital outflows from China, which were partly driven by expectations of a rate hike by the Federal Reserve. As the Chinese economy rebalances and settles on a lower GDP growth trajectory and advanced economies such as the US continue to recover from the Global Financial Crisis, expectations of relative returns will narrow and expose a potentially fragile Chinese financial sector to uncertainty and turbulence. IMF research also shows that a 1 standard deviation increase in global financial market volatility for 1 year can subtract 0.2-0.4% from GDP for China, India, Japan, the US, the Euro Area and the UK.
China is on an untested transition path that is likely to be long and bumpy. Ultimately this process will leave the economy less dependent on exports and imports, but given the size of China’s economy, the depth and breadth of its financial linkages with the rest of the world and its various domestic imbalances, any large shock that emanates from China will undoubtedly impact the rest of the world with potential feedback effects.
- Global economic growth is
made in China. China has been the most dominant contributor to global GDP
growth for a number of years and if IMF forecasts materialise, it will contribute
over 30% to global economic growth this year.
- Exports and
imports have become less important for China, mainly because of currency
appreciation and slower investment spending.
- The US and
China are joined at the hip. US imports from China continue to rise. The
manufacturing sector deficit has widened by 15% over the past two years and the
US accounts for 60% of the Chinese manufacturing sector surplus. There is a 70%
correlation between US domestic demand growth and Chinese export growth to the
- The US economic recovery is a double-edged sword for China: China will undoubtedly
benefit from stronger US domestic demand through the trade channel, but China
is vulnerable to a rapid US rate hiking cycle. China is particularly exposed if
its economic growth prospects deteriorate at the same time.
- An economic
shock in China will reverberate across the world. Credit continues to grow
rapidly in China. Research on past episodes shows that China is vulnerable to a
financial crisis and it would be unusual for the economy not to suffer a
prolonged economic slowdown of around 4% should the country suffer a full-blown
banking crisis. A crisis of that magnitude could subtract around 1% from global
Stephen (29th August 2016): Global Growth – Still Made in China. Project
Syndicate, available at: https://www.project-syndicate.org/commentary/china-still-global-growth-engine-by-stephen-s--roach-2016-08
Bai, Chang-Tai Hsieh and Zheng Song (2016): The Long Shadow of Fiscal
Expansion. Brookings Papers on Economic Activity, BPEA Conference Draft,
September 15/16 2016
Zhang (2016): Rebalancing in China - progress and prospects. IMF Working Paper
Miner (February 8th, 2016): China’s current account in 2015: A growing trade
surplus. China Economic Watch, Peterson Institute for international economics
Cashin, Kamiar Mohaddes and Mehdi Raissi (2016): China’s slowdown and global
financial market volatility: is world growth losing out? IMF Working Paper
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