Top of Mind: China Bumps Won’t Derail Global Growth
The following Q&A appeared in the February 10, 2016 issue of "Top of Mind" from Goldman Sachs Research. Goldman Sachs economists Jari Stehn and Elad Pashtan discuss the severity of the spillover effects we can expect from China’s economic slowdown on other economies around the world.
Recent market turmoil has raised a number of concerns about the implications of China’s "bumpy deceleration" for global growth. Below we ask and answer some key questions in this context, generally finding that risks to the largest economies appear limited and manageable.
Q: If China growth slows more seriously, how big are the spillovers to DM growth?
A: Probably not very big. The main reason is that exports to China, and more broadly to Asia ex-Japan, as a share of GDP are small—around 1%—for most DM countries with the exceptions of Australia, Japan, and Germany. This means that even if Chinese import volumes were to decline by 10% across the board due to a combination of Chinese domestic demand weakness and CNY depreciation—a very severe assumption— this would only take 0.1pp off DM GDP growth directly.
Q: What are the global implications when we consider indirect trade linkages via third countries and transmission of financial shocks across countries?
A: In our global economic model, developments in China can affect growth, inflation, and the policy rate in other economies through three channels—1) weakness in Chinese domestic demand that reduces foreign net exports, 2) a depreciation in the CNY that increases Chinese net exports and lowers inflation abroad via pass-through effects, or 3) a tightening in Chinese domestic financial conditions that spills into other countries’ domestic financial conditions and thereby reduces consumption or investment demand abroad. We have modelled each of these shocks in a size that broadly resembles the changes in forecasts and market conditions over the past year.
Perhaps not surprisingly given the relatively modest trade exposures, the spillovers of either domestic demand weakness in China or a moderate exchange depreciation similar to what we have seen recently is not large, in each case below for all of the major economies. The impact of a domestic FCI tightening in China is also not very large, owing primarily to the typically limited pass-through from domestic Chinese financial markets to the rest of the world. Implications of any of these shocks for either inflation or policy rates in partner countries are likewise relatively small.
Q: How bad could it get?
A: Let’s look at a few scenarios—all on the aggressive side in terms of the deterioration in China but quite different in terms of the goals and efficacy of the policy response. In each scenario, we assume that domestic demand growth in China slows by a further 2pp. In the first scenario—"currency defense"—we assume no further change in the CNY from current levels, but a substantial tightening of the China financial conditions index (FCI). The idea is that the Chinese authorities manage to stem the devaluation via higher rates and other measures that tighten domestic financial conditions. The second scenario—"adverse devaluation"—assumes the same Chinese policy stance and implications for the domestic FCI, as well as a 10% CNY depreciation as the currency defense ultimately turns out to be unsuccessful. Finally, in the third scenario—"benign devaluation"—we assume that the Chinese authorities allow a 10% CNY depreciation and manage to substantially ease the domestic FCI.
In the "currency defense" scenario, GDP growth in China slows by the full domestic demand hit. Conversely, in the "benign devaluation" scenario, growth in China slows only modestly as a more competitive CNY and domestic FCI easing offset almost the entire hit to domestic demand. "Adverse devaluation" is in between the two other scenarios from China’s perspective, though it imposes moderately higher costs on other economies. The upshot from our analysis is that most of the differences between the three scenarios fall on China itself, while the spillovers into DM economies appear manageable. That being said, the markets can create their own reality, at least up to a point, via the sharp tightening in financial conditions, so it is important to watch this indicator closely.
Q: But is the US equity market sell-off telling us that spillovers are larger than what the models are capturing? Does it imply heightened US recession risk, whether from China or other factors?
A: The latest pullback does not necessarily signal a sharp downturn in the broader economy. Although equity selloffs do coincide with most recessions, large selloffs do not necessarily presage recessions. In 2011, for example, a 19% decline in the S&P 500 between July and October did not coincide with or precede a recession.
It is important to keep in mind that there are key differences between the US equity market and the broader US economy. As far as exposure to China and other non-US markets is concerned, publicly traded firms tend to be larger than their private counterparts and are much more likely to sell their goods abroad. The median S&P 500 firm derives roughly one third of its revenues from overseas, while total exports account for just 12.5% of GDP. Accordingly, the S&P 500 is more likely to face headwinds from a strengthening US dollar and a growth slowdown abroad. In addition, publicly-traded companies and the economy as a whole do not comprise the same set of industries. Energy, for example, has a much larger weight in major equity indices than it does in the broader economy (and has been the worst-performing sector in recent months).
These and other differences may imply that the current weakness in the US equity market overstates the headwinds facing the real economy—although any further equity market declines incrementally increase the odds that economic growth may be slowing.