How China’s slowing economy could drag down the Global economy?

Known for the world’s factory and its manufacturing might, China is no doubt home to a rapidly-growing affluent population that is beginning to flex its spending muscles. More than three decades of nearly double-digit growth have not only fired the country’s rapid rise to the world’s second-largest economy, but also immensely improved the standards of living of its 1.3 billion people. Unfortunately, the bigger an economy gets, the harder it is to keep growing at a fast pace. A single-digit soon becomes an inevitable reality where China’s economy has indeed grew at its slowest pace since 2009 last quarter, with output, investment and retail statistics pointing to a deep slowdown. Growth is a function of increased productivity, labour and capital; when all three increased, as they did for China for many years, growth rates were excellent. However, these factors are slowing down now. China has just cut its growth target for 2015 to 7%, which would be the slowest expansion in more than two decades.

An economy-wide inflation indicator turned negative for the first time since 2009, suggesting room for further monetary easing. This has indeed raised alerts for deflation risks and policy makers have to take action soon.

 

Crippled with a heavy repayment burden

One of the most recent trends that explains China’s sharper-than-expected slowdown is its credit binge. Total debt has mounted to approximately 250% of its GDP, up 100 percentage points since 2008. This happened when the United States and Europe, China’s biggest export customers, went into recession. In order to shore up its economy, China announced a stimulus package of $586 billion, almost 13 percent of its GDP, in late 2008. While this debt has helped China fuel its economy through the global financial crisis, it has also crippled the economy with a heavy repayment burden . Local governments are now finding it hard to cope with debts and tax receipts especially when land sales have taken a hit from the slowing economy. In fact, Finance Minister Lou Jiwei has mentioned that China’s slow growth has already cut into fiscal revenues, making it increasingly difficult for the government to reach its expected full-year revenue target.

Deflation risks on the high

China’s slow growth implies that there is now a slowing demand where consumers are consuming lesser goods and services. This would no doubt cause factories and production to produce lesser goods and services as compared to before. A vicious cycle to an economy depression is about to kick off when deflation sets in and unemployment starts rising. In a world that has come to rely on China to keep the global economy ticking, a faltering China could easily tip the world back into recession. The demand for industrial commodities will definitely slow down and this affects all resource producer countries such as Argentina, Brazil, the Middle East, Central Asia, Africa and Australia (Yang 2015). In fact, copper prices are already falling to a six-year low, Shanghai nickel futures are sliding by their 5 percent daily limit and oil prices are equally falling towards a three-month low of $56 per barrel.

If it is not apparent enough, China’s slow growth does have a knock-out effect on demand for oil. As they are the largest importer of oil, if there is a one percentage point drop in the growth of China’s industry production, it can affect the oil price to fall almost two percent lower than expected. A fall in oil prices alone can trigger a ripple of effects to many countries; while Asian governments can now ease the cost of fuel subsidies, it can become increasingly difficult for OPEC members to yield a sustainable amount of income.

China’s stock market crash

Furthermore, the introduction of China’s stimulus package of $586 billion has caused investors to purchase shares and properties with borrowed money. Many had predicted stocks to be under-priced, possibly reflecting memoirs of the earlier 2008 global financial crisis, and began chasing after these shares which led to higher prices. “Investors were speculating [added] government policies to spur growth,” said one market analyst. With China’s economy slowing to a two-decade low of 7%, stocks eventually became disconnected from the economy’s performance. The classic bubble that was long overdue, burst ultimately.

The Chinese markets which escalated as much as 110 percent from November last year to hitting its peak in June 2015, has crumbled at an exceptionally rapid pace, losing more than 20 percent in extreme volatility as money floods in and out of the market. This diminution has nearly wiped out $3 trillion in market capitalization. The Shanghai Composite Index opened at its lowest point on Jul 8, 2015 and to prevent their share price from free-falling, more than 500 China-listed companies have chosen the escape route by having their shares suspended, amounting to approximately $2.4 trillion worth of stock. Despite this, the first country to take the beating is Hong Kong’s Hang Seng Index which fell by 5.8 percent and according to Bank of New York Mellon, Chinese stocks on U.S. exchanges have also fell as much as 6.1 percent. This market selloff is likely to continue for an extended period as many investors would be forced to liquidate their portfolios in an attempt to recoup their borrowed money. An equity market heavily dependent on borrowed money is now causing investors to nurse big losses that may take a long time to heal.

Hurt by a housing slump and a downturn in investment and manufacturing which caused the world’s second biggest economy to slow down, the Ministry of Finance has initially decided that expanding domestic consumer demand is a more imperative step in rebuilding stable growth and stimulating structural reform in China. However, with the recent market failure which caused its stock market to soar and crash, the Chinese government is now facing a more difficult transition to the higher-value, more efficient and market oriented economy needed to sustain the next phase of development. Confidence has been lost in many international investors and regulators as they may very well be more cautious now than they were a month ago.

Marc Faber, a long-time bearish investor has agreed that this would have a huge impact on the global economy. Rechir Sharma of Morgan Stanley has also supported that this crash could depress the Chinese economy by eroding confidence where its effects would be felt by other countries. Analysts of Bank of America Merrill Lynch have noted that the ripple effects has yet to show up and it is likely to be reflected in slower growth in many Asian countries, poorer corporate income and a higher risk of a financial crisis.

China’s risk is now everybody’s risk.

It is clear that China is moving towards an economic reform of reducing the role of the government for market forces come into play instead. However, given the market decline over the past two weeks, it is likely that market reforms will now be slower than expected. Eswar Prasad of Cornell University has argued that China’s Communist leaders will lose their appetite for overhauling the economy, and will now move away from export-led growth and rely on stronger consumer spending instead. This may also be better as import taxes would be lowered on average by over 50 percent in an attempt to drive consumer demand on a wider selection of imported goods.

With sound macroeconomic policies and continuous efforts to deepen reforms, China will neither allow the economic slowdown to go too broad and deep to disrupt its pursuit of two centennial goals, nor excessively boost growth at the expense of sustainability and quality. Furthermore, with consumer-price inflation (CPI) operating at a five-year low of 1.1% and producer prices deep in deflation, it could be possible that China’s economy being controlled by the government deliberately, is performing below its potential.

The tools Chinese policymakers can use to ensure slower but sustainable growth are plentiful, including substantial fiscal headroom, and healthy external payments and liquidity buffers. Yet what’s more important may be China’s fiscal, monetary and financial system reforms, as well as other regulatory reforms that are ongoing. Such structural reforms will take time to gain traction, but they are essential to the fundamental restructuring and rebalancing of the Chinese economy in the new normal era.

Besides, with the amount of leverage China has worked at the eleventh hour to keep the stock market up, it is likely that China has deeper pockets than we know.

 

References

Anonymous. 2015. “China slashes tax on foreign goods to help boost slowing     economy.” South China Morning Post.

Barron, O.B. 2015. “Did China’s Stock Market Crash Just End Economic Reform?” Forbes.

Gu, W. 2015. “Chinese investors pull back from margin funding.” The Wall Street Journal.

Hilton, I. 2015. “China’s stock market crash is a problem for the whole world.” The Guardian.

Orlink, T. 2015. “China’s Economy slows to its weakest since 2009 as output wanes.”     Bloomberg News.

Samuelson, R.J. 2015. “China’s coming crash?” The Washington Post.

Samuelson, R.J. 2015. “The danger of China’s crash.” The Washington Post.

S.R. 2015. “Why China’s economy is slowing.” The Economist.

Sheffield, H. 2015. “How China’s slowing GDP growth could drag down the global         economy.” The Independent.

Shen, S. and Goh, B. 2015. “China stock market freezing up as sell-off gathers pace.” Reuters.

Sweeney, P. 2015. “Chinese stocks tumble again, ignoring Beijing’s blandishments.” Reuters.

Yang, S. 2015. “Marc Faber: The biggest threat to our global economy.” CNBC.

Yao, K. 2015. “Slower China growth put pressure on government revenues – Finance   Minister.” Reuters.

Zhu, Q.W. 2015. “China’s economic slowdown promises fresh opportunities.” The          Telegraph.

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