August's financial turmoil can be attributed to fears of seeing world growth decelerate. The adjustment to China's exchange rate regime and the fumbled communication by the Chinese authorities as to their actual intentions are responsible for the wave of panic that began to overtake (and continues to roil) the financial markets.
For some observers reading between the lines, the haste on the part of the Chinese authorities showed that (1) the downturn in China was worse than expected and (2) the local authorities were prepared to stabilise the economy using every means available. As a result, talk of a “currency war” has returned to the fore and fears of a cascade of devaluations are causing several Asian currencies, implicitly tied to the RMB, to vacillate (Asia has largely become a “yuan zone”).
Since China is the world's No. 1 importer of raw materials, commodity prices tumbled, leading to currency depreciation (mainly the currencies of commodity-exporting countries). A mini vicious circle has formed in which depreciating currencies and lower commodity prices are reinforcing one another. Next, the shock wave hit the equity markets of Asia and other parts of the world.
It is clear that there has been a game change for many countries in this new macrofinancial climate (reduced revenue for commodity exporters, which has tightened budgetary constraints, higher inflation due to the pullback of currencies and more uncertainty resulting from capital outflows and falling equity markets). Besides China, other large emerging market economies, already considerably weakened, are under further pressure (Brazil and Russia). Against this backdrop, the growth of emerging economies as a whole will be substantially weaker than expected in 2016.
In China, the slowdown in activity in the manufacturing sector began several years ago but has very obviously accelerated during the first half of 20151. At the same time, we noticed, for the first time since 2008, a slowdown in global trade in the first half of the year The combined effects of these two developments, which are largely independent from each other, added to fears about a shock to the global economy. So, what conclusions should we draw from this?
In the following discussion, we will focus exclusively on the transmission channels via the real economy2 and conclude with two points: (1) the Chinese economy's real weight in the global economy is far less than generally suggested and (2) the slowdown in global trade, which is structural in nature, will allow those economies with a robust domestic growth engine to more easily decouple from external shocks. This may provide some reassurance regarding world growth momentum in the short term. However, this should not overshadow the general slowdown that lies ahead in the medium term.
What is China's actual weight in the global economy?
This may come as a surprise. For many observers, China's economy became the largest economy in the world in 2014. Although it is clear that its size has grown steadily over the past 15 years, the ranking of economies is open to challenge. It is the calculation of China’s GDP converted to US dollars using purchasing power parity (PPP) exchange rates that leads many observers to conclude that the Chinese economy is larger than the US economy (16.6% of world GDP vs. 16.1% for the United States in 2014). To fully understand these issues, further explanations are needed on the method used to arrive at this result (see box).
The calculation based on PPP exchange rates is partially fictive and aims, first and foremost, at ensuring the comparability of regional or global aggregates over time. Conversely, at some point in time, you could argue that what ultimately counts for global economic activity (and for corporate earnings) is the size of each economy at current prices and at prevailing foreign exchange rates. The same is true when estimating the actual contribution of an economy to global growth or the effects of a shock propagated by trade.
The weight of China has admittedly quadrupled in 15 years but in current dollars its economic weight remains much lower than that of the United States (13.3% vs. 22.4% in 2014). Although the weight in the global economy of the G-3 (the United States, the EU and Japan) has clearly been declining for the past 15 years, it still represents more than 50% of global GDP (vs. more than 70% in 2000)3.
The practice of using GDP-PPP weights to calculate global growth ends up overestimating the contribution of China and emerging Asia and minimising that of advanced countries. However, in the short run, calculations using market exchange rates undoubtedly better reflect the spillover into the global economy and into corporate earnings.
This is to say nothing of the fact that to measure the role of the consumer on a global scale, you also have to factor in percentage of GDP that consumption represents (approximately 40% in China vs. 70% in the United States). Ultimately, the “US consumer” weighs three times more than the “Chinese consumer” (15.7% of global GDP vs. 5.3%).
Global trade: the slowdown is structural
In the past few years we have seen a very sharp slowdown in global trade with no direct link to the slowdown we are seeing in China. Between 1992 and 2007, the growth in world trade was nearly twice that of global GDP (7% vs. 3.8%). The worldwide financial crisis of 2008 marks a break from the trend. For the past four years, the growth in global trade has been 3%, less than half of what it was over the 15 years prior to the crisis. Global GDP has also slowed, albeit to a lesser extent (3.6%). Today world trade is more closely aligned with global GDP (close to 3%).
Technically, the difference in growth between world trade and global GDP means that the elasticity of exports (or imports) in global GDP (in domestic GDP) was much higher than 1 between 1992 and 1997. In other words, during this period each GDP-growth unit resulted in higher trade flows, which ultimately made a positive contribution to global growth. This period coincides with the acceleration of globalisation and the increasing fragmentation of the production process, which seems to be over (see box). Developments in world trade have become more neutral as far as growth is concerned4.
There's some good news and some bad news in this. The good news is that the effects of propagation via the trade channel are weaker today than in the past (in particular during the big financial crisis of 2008). The slowdown in Chinese growth may not threaten trade as much as feared. The percentage of exports from advanced countries to the Asia region -and to China in particular- has admittedly sharply increased over the past 20 years (see graph). But as these exports have become less sensitive to the growth of emerging countries, the ultimate impacts will be mitigated. In other words, “trade multipliers” are falling and the dynamics of world growth are becoming (or once again becoming) more dependent on the domestic demand of each country (this is true in advanced countries and emerging countries alike). Under these circumstances, the redistributive effects on consumption in advanced countries stemming from falling commodity prices (in a time when domestic fundamentals look encouraging for domestic demand) may easily outweigh the negative effects propagated by world trade. If this trend continues, we may witness a disconnection of economic cycles between one country and the next in the future.
The bad news, on the other hand, is that it will be harder for an economy to stabilise its business cycle by relying on external growth (via a devaluation in the exchange rate) or, to put it differently, harder to export (or import) deflation via the exchange rate channel. This will only increase the pressure on the usual stabilisation policies (fiscal and monetary) even though the degrees of freedom in this area are considerably reduced (debt constraints for some countries, zero interest rate policies implemented by the central banks) and where the marginal impact of any new QE measures will be low. Subsequently, economic cycles promise to be far more uneven than in the past.
In the near term, the relative strength of domestic demand in the advanced economies should offset the slowdown in China and the contraction of world trade; however, global GDP and world trade are likely to converge with muted growth momentum in the medium term.
Despite the rapid development of emerging economies over the past 15 years, the global economy ultimately remains far more dependent on the consumption of the advanced economies than on that of the emerging economies. The “consumer of last resort” remains the US consumer and, albeit to a lesser extent, the “European consumer”. This is good news in the short term due to the powerful redistributive effects that consumers in developed countries will be feeling due to the plunge in the price of commodities. In 2015-2016, domestic demand in the advanced economies should be sufficient to offset the contraction of world trade and the slowdown in China. This is very likely what the disparity in survey results across the manufacturing sector (which are deteriorating) and the services sector (a sector that by nature is more domestic and sound) is reflecting in most countries (including China).
On the other hand, in the medium term, the growth rate of world trade will be dependent on potential GDP growth, which is at a far lower level that in the past. In fact, most countries will see their growth potential diminish due to the sharp drop in total-factor productivity and ageing populations (lower growth or even negative labour-force growth). In the United States, growth potential is estimated to be along the lines of 2% (compared to 3% pre-crisis). In the eurozone, it is barely above 1% (compared to 2% prior to the crisis). However, it is undoubtedly in the emerging economies where the downturn will be the most precipitous (because they have further to fall). This suggests a slow convergence of global growth (GDP and trade) with a level that is likely less than 3% on average.
While the IMF recently issued a warning on lower potential world growth, it said nothing about a slowdown in world trade and the implications of such a combination. We have provided a quick review of the possible causes. The consequences are manifold. We'll limit ourselves to mentioning only three: (1) profits will grow much more slowly than they did in the past (especially for the most globalised companies) –which will impact equity market valuations –, (2) macroeconomic cycles will be more domestic in nature and more volatile than they were in the past, and, last, (3) the threat of deflation will re-emerge in the event of an exogenous shock (the case of China in 2015 provides a perfect example). In such an environment, the QE policies pursued by central banks will have many fine days ahead of them.
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2 We will not be addressing the financial channel (short-term equity market contagion) as we hold the view that ultimately -once the turmoil associated with uncertainly subsides- the real economy (economic growth, inflation, profit trends) will serve as an anchor for the financial markets.
3 Note that the depreciation of emerging market currencies in 2015 is likely to widen the gap between emerging Asia and the advanced economies.
4 However, in the short run the contraction in global trade is going to have a negative impact on growth.
In the first half of the year, global trade contracted for the first time since 2008
The G-3 (US, EU and Japan) still weighs much more than Asia ex-Japan
The “US consumer” weighs three times more than the “Chinese consumer” (15% of global GDP vs. 5%)
Countries are in the process of refocusing their growth model on domestic demand
The world economy is converging towards a weaker pace of expansion