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The Economic Slowdown in China: When China Sneezes…

by Chris Russell

December 16, 2015

When-China-Sneezes

As the economic slowdown in China settles in, which countries are at risk of catching a cold?

On a five-day tour to China in September, George Osborne, the UK’s Chancellor of the Exchequer spoke in glowing terms about his hopes for the future of the countries’ economic relationship, saying: “Our message to China is very clear: we want the UK to be China’s best partner in the West.” As part of his vision of a “golden decade” in UK-China relations, Osborne set out his aim to make China the UK’s second-largest trading partner by 2025, displacing Germany.

Xi Jinping, for his part, seemed happy to recognize the UK’s China love—in a written interview with Reuters ahead of a state visit to the UK in October, he described it as a “visionary and strategic choice”, and a host of deals were signed during his time in the country, with British companies set to export satellite technology, liquid natural gas, jet engines and more. And that comes in addition to existing British exports to China, which include everything from Burberry jackets to pig semen, the latter as part of a £45 million-a-year ($69 million) deal.

But as Asia’s heavyweight adjusts to the so-called ‘New Normal’, the question arises of how countries such as the UK will deal with increased exposure to a China that is no longer posting the dizzying growth rates it once was, and which some experts feel is on the verge of a significant economic slump. While the UK is only now forging major economic links with China in earnest, others have been hitched to China’s economic growth for years. So when China does sneeze, who catches a cold?

Passed Around

China’s economic boom, which chiefly involved marshaling massive amounts of resources in service of construction and manufacturing, required huge imports in order to maintain that momentum, and as such commodities and capital goods—those used in the production of other goods—have been its main imports from other countries. Yet as the country’s investment and construction drive comes under pressure and low-end manufacturing enters into decline, demand for these imports is falling, with knock-on consequences for the countries that provided them.

Chart-001

“The ones who are most affected are the ones who benefited a lot from the commodity price surge, and they are also the ones who are most affected on the downslope,” says Yukon Huang, Senior Associate at the Asia Program for the Carnegie Endowment for International Peace. “[Commodity exporters are] feeding into primarily the construction surge in China—the property market, industrial production—and that’s essentially China’s domestic market.”

That includes countries such as Brazil, Australia, Russia, Mexico, Chile, South Africa, Malaysia and Indonesia. Unsurprisingly, some of these countries are also the most dependent on China as a share of their total exports—according to figures from UBS, for Australia this represents a whopping 33.7%. Australia and Malaysia are amongst the most economically exposed overall, with exports to China constituting 5.6% and 11.5% of GDP, respectively.

In terms of capital goods exporters, Germany and Japan are both sensitive to a slowdown in the Chinese economy, with capital goods exports from the former representing the bulk of its exports to China. Bulgaria and Finland also find themselves in a similar situation, but in general the EU would seem more than able to cope with China’s slowdown and may even find it something of a mixed blessing.

Writing in a commentary for the Centre for European Policy Studies, Cinzia Alcidi and Mikkel Barslund, Head of the Economic Policy Unit and Research Fellow for the Brussels think tank, respectively, note that “since slower Chinese growth goes hand-in-hand with lower commodity prices, the latter is likely to provide EU countries with a strong offset for lower Chinese export demand … Furthermore, the burden of the slowdown is likely to fall on the EU’s broadest shoulders and, in fact, may even contribute to a rebalancing within Europe.”

Meanwhile for Japan, the effect is felt much more strongly: China represents a much higher percentage of its exports compared to the EU—21.5% versus 9.6%—and those exports represent 3.2% of GDP. According to the OECD, a two-percentage point decline in Chinese growth for two years combined with financial turmoil could shave over half a percentage point off the Japan’s already anemic growth.

But when looking at the headline figures, it is also important to distinguish between those exports that are intended for China’s domestic market and those that are ultimately destined for other markets. In the latter case, goods are exported to China, where they are then processed or assembled before being exported to other countries, what Huang calls the “production sharing network”. China’s regional trading partners play a significant role here.

Despite ranking amongst China’s top sources of imports, exports to China for domestic use only constitute 49.9%, 46.3% and 29.9% for Vietnam, South Korea and Taiwan, respectively, according to figures from UBS. Owing to its substantial exports of capital goods, the figure for Japan stands somewhat higher at 68.3%. Thus such exports won’t be affected by a slowdown in China, although expanded Chinese productive capacity could dent these figures going forward.

What is more certain is the affect reduced trade as a result of China’a slowdown is having on the shipping industry—in September, Chinese imports fell for the eleventh month in a row and by 17.7% year-on-year. In October, A.P. Moller-Maersk—a bellwether for the industry—cut its full-year profit guidance, citing weaker global demand for container shipping.

Strong Immunity

But when looking at countries with the greatest exposure to China, one is conspicuous by its absence—the US. Despite playing a leading role in the global economy, experts largely consider it to be insulated from any slowdown in Chinese growth.

“In terms of trade linkages, the US is indeed not very exposed to the slowdown in China. In fact, such impact may even be offset by the global disinflationary pressures, which could boost real income in the US, aiding consumer spending,” says Michelle Lam, economist at Lombard Street Research, citing research from the firm’s team of economists.

And Huang agrees: “The US is essentially not very much trade dependent, period. It’s a country which is essentially not affected by global trade patterns, but people think it is. It’s because it’s self-contained and mainly because it’s services-oriented.” Indeed, exports to China only represent 0.8% of US GDP according to UBS, although those intended for China’s domestic market stand at a relatively high 76.9%. Moreover, both Canada and Mexico remain more important trade partners for the US.

But the big picture overlooks some key nuances. Certain states are much more dependent on Chinese imports than others: according to a report by the US-China Business Council, Alaska, Oregon, South Carolina, South Dakota and Washington all had China as the top destination for their exports in 2014.

And certain sectors and companies are also much more reliant on China. According to the MSCI World with China Exposure Index, five US companies, including Qualcomm and Texas Instruments, are in the top 10—and these are primarily in the tech sector. In addition, Apple, Yum Brands and the US agriculture sector generally also have a high degree of exposure. Even so, there’s is still a degree of resilience.

“[Agricultural products] are not as affected by a slowdown because food consumption doesn’t tend to dive. It moderates a little bit but it doesn’t fall as dramatically as commodities or machinery,” says Huang, who is fairly sanguine on the overall effects. “US exports are affected only a little bit, but not very much. I would say it’s the last one to be really affected.”

Meanwhile US Treasuries, which China has been a long-standing and significant holder of, have largely been unaffected by China’s slowing economy. That’s in spite of China paring back its stake and is due to US domestic demand being stronger than it has been in years. However, China’s interest rate cut in late October was enough to spark a significant sell off, indicating the impact the country can still have on the US government debt market.

Varied Vectors

But trade isn’t the only way in which China’s economy can have implications for other countries, and various macroeconomic events and policy decisions can, to varying degrees, reverberate around the world.

In terms of China’s financial sector, the country’s build up of debt has been a persistent source of worry for economists, and a debt crisis, although widely considered to be manageable, would nonetheless dent Chinese economic performance. Yet the immediate effects beyond China’s shores would be fairly limited. “China has limited external debt so financial distress should have limited implications for the rest of the world (apart from Hong Kong and Taiwan),” says Lam.

That said, some countries have greater exposure than others. According to Fitch, UK banks had $92 billion of assets exposed to mainland China at the end of 2014, and that didn’t include HSBC or Standard Chartered, two banks with a heavy focus on Asia. That total wasn’t far off the amount for North America, which had $116 billion of assets exposed to the mainland. Unsurprisingly, Hong Kong came out on top with a figure of $869 billion.

Exposure to China’s debt could increase further, with Li-Gang Liu, Chief Economist for Greater China at ANZ, noting that “foreign capital and foreign financial institutions could be part of the solution in solving China’s debt problems.” That could happen if there were further listings by big state-owned enterprises on the Hong Kong or Shanghai stock exchanges, he says.

The latter exchange and its Shenzhen counterpart have been a source of concern for global investors, especially since their fall in the summer. But despite innovations such as the Hong Kong-Shanghai Stock Connect, which launched in 2014 and increased access of foreign investors to mainland markets, mainland bourses have little relevance for those offshore (although that could also change—Osborne proposed the creation of a London-Shanghai stock connect during his China trip).

Moreover, they have very little relation to the overall health of the Chinese economy. Global markets went into a brief meltdown after the Shanghai and Shenzhen exchanges tanked over the summer, but Huang points out that this was a psychological reaction based on China’s sheer economic size rather than the result of any direct connection to global markets.

That in turn caused the US Federal Reserve to delay a long-anticipated interest rate rise until 2016, with chair Janet Yellen citing China’s economic slowdown as part of its reasoning. But Huang suggests this is more to do with the aforementioned flawed perceptions than it is about actual economic implications. “[If] companies and banks believe that [China] is collapsing, then you can’t change your interest rate because you’re going to make the situation worse. So this is a very interesting case of a false perception affecting policies in the US.”

But the most important area for other countries, and the one with the most visceral effects, is the valuation of the renminbi, which was devalued in August upon a revision to its valuation scheme.

“While the euro area, Japan and ASEAN countries are likely to be affected by yuan devaluation, we have long argued that the yuan is overvalued, and yuan weakness will indeed help China’s rebalancing from investment to consumption—this is beneficial for the rest of the world,” says Lam. “But of course, it is only if the rest of the world are prepared to accept such adjustment.”

With central banks set to continue programs of quantitative easing, in the future there may be successive rounds of currency devaluations, from which Lam says “no one will gain”.

Closer Contact

As its domestic market continues to grow, the effect on the value of exports to China will depend on a number of factors that will differ from country to country.

In part, it depends on how trade linkages evolve globally, and in this respect the Trans-Pacific Partnership (TPP)—which does not include China—has the potential to be particularly important. With the reductions or elimination of tariffs and the harmonizing of standards, participating countries such as the US, Australia and Japan will all have new trade incentives.

Then there is the evolving nature of the Chinese economy as it moves away from being investment-oriented, something that Huang thinks could make its market less important for current trading partners.

“Consumption tends to be less import intensive, investment is more import intensive, so a more consumption-driven Chinese economy, as opposed to investment-driven essentially requires less imports from overseas,” he says. “That’s one reason why China’s imports have slowed a lot—its consumption has held up reasonably well but its investment has not… In some ways the world is better off if China actually continued to invest, if it were sensible to do so.”

That is partly due to the fact that China’s economy is still not as open as it could be, with foreign participation still closed or limited in many sectors. That’s particularly true of services, where advanced economies are strongest—OECD statistics show services represented 30% of the US’s gross exports in 2014. According to the OECD’s Service Trade Restrictiveness Index, China has above average restrictions in all recorded sectors except architecture—and these include important areas such as banking, shipping, telecoms and insurance.

That could change with the signing of trade agreements such as the US-China Bilateral Investment Treaty (BIT), which would see China move to a ‘negative list’ of sectors not open to US participation. Other deals could include an EU-China free trade agreement, with Xi and UK Prime Minister David Cameron calling for the launch of a feasibility study during the former’s state visit, and even Chinese involvement in the TPP has been mooted by analysts and Chinese state media. But all that remains hypothetical, and there were no substantial breakthroughs in BIT negotiations during Xi’s US state visit in September.

Greater openness could still come through China opening up its capital account as part of its bid to join the IMF’s Special Drawing Rights, and that will benefit economies with a sophisticated financial services industry, says Li-Gang Liu. Combined with a continued or steeper slowdown, that could see less capital going into China and more going out.

“This means that certain Chinese capital will flow to financial centers such as Hong Kong and Singapore, and ASEAN economies could get a bigger share of capital flow from OECD economies, so in that sense I think [a slowdown] might not be a bad thing for ASEAN economies,” he says.

In any case, China is now one of key drivers of global growth, particularly since the financial crisis, and any slowdown will have global ramifications with knock-on effects for everyone irrespective of their direct exposure. That said, many of the world’s advanced economies can take heart from the fact that the direct impacts are nonetheless limited and the alarmist headlines following China’s turbulent summer can be taken with a pinch of salt. When China catches a cold, the main country that suffers is itself.

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