How a Chinese storm would hit the UK economy
We examine what would happen to UK growth and interest rates if China suffered a 'hard landing'
1:53PM BST 29 Aug 2015
Just when you thought the era of ultra loose monetary policy was coming to an end, China's hiccup has caused shockwaves around the globe.
The world's second largest economy is losing momentum. Exports are tumbling, factory gate prices are falling, and fixed investment is climbing at its slowest pace since 2000.
China's transition to slower, more sustainable growth has been well trailed. Seven months ago, Chinese premier Li Keqiang stood in front of the great and the good at Davos, Switzerland, and said China's "new normal"meant the magic 7pc growth it had enjoyed through all but the depths of the 2008 financial crisis was a thing of the past.
However, he said China would not enter crisis mode.
"Regional or systemic crisis will not happen in China. Nor will there be any hard landing," he said.
Li Keqiang, China's premier, speaks during a session at the World Economic Forum (WEF) in Davos, Switzerland Photo: Bloomberg
Recent events suggest the Chinese economy could be more fragile than previously thought. In June, a stock market rally that saw China's benchmark index double since the end of 2014 came to an abrupt end after Chinese authorities tried to curb investors from buying stocks with borrowed cash.
With the world gripped by the prospect of a Greek exit from the eurozone, panic was contained within China. Analysts said the sell-off merely reflected a reality check following moves to relax so-called "margin trading rules" in previous years. A correction was always on the cards.
August 11 changed this thinking. China's move to devalue the renminbi for the first time in modern history signalled a new era in how policymakers will manage the exchange rate, triggering panic in a month where liquidity is in short supply.
As fears grew about the Chinese government's ability to control the slowdown, a stock market sell-off ensued. China's "Black Monday" saw one trillion dollars wiped off global bourses in a day.
While it is uncertain if the stock market gyrations will hit the real economy, China responded by cutting interest rates for the fifth time in nine months and relaxing lending rules. Markets rallied. Central bankers also waded in, keen to assure everyone that the punch bowl would not be taken away while the global economy remained fragile.
All eyes are now focused on the Federal Reserve, and whether policymakers will begin to raise interest rates in September. Policymakers on Threadneedle Street will also be pondering what impact events 5,000 miles away in Beijing will have on the UK.
Chancellor George Osborne said Britain was “much better prepared than we would have been a few years ago for this kind of shock”, but the economy was “not immune” from the fallout of a Chinese crisis. But how bad would a hard landing in China be for the UK?
Headwinds from the East
Chinese president Xi Jinping is expected to unveil a wave of trade deals during his state visit to Britain in October. Jim O'Neill, the UK's commercial secretary to the Treasury, said last month that there were a number of areas in which deeper co-operation between the UK and China could help to create stronger, more sustainable growth.
However, a Chinese slowdown is likely to hit UK growth through trade. The country is Britain's sixth biggest export market, representing 4.8pc of total UK exports in 2014, according to the Office for National Statistics (ONS). This is up from 1.5pc a decade earlier and just 0.5pc when records began in 1997.
Despite its growing significance to UK growth, Martin Beck, an economist at Oxford Economics, describes China’s importance to UK GDP as a whole as "still fairly trivial". Goods exports to China in the second quarter amounted to £3.2bn - or 0.7pc of GDP.
According to Oxford Economics, if China manages to control its transition from investment-led growth to a consumption-driven expansion, a "soft landing" would see growth ease from 6.6pc this year to 5.3pc by 2020.
The UK economy would remain robust, growing by 2.6pc this year, 2.8pc in 2016 and 2.7pc in 2018.
Analysts at Investec also believe UK growth would weather a storm in China. "Domestic drivers remain positive and there are signs that a long awaited revival in productivity is finally here," said Philip Shaw, an economist at Investec. Growth is expected to hit 2.7pc in 2015 and 2.8pc next year.
As the International Monetary Fund highlighted in a recent assessment of the Chinese economy, if it doesn't endue reform and the volatility, it could really face a "hard landing".
Repeated reliance on credit and government intervention to prop up growth without reforms would boost near-term growth, but reduce future growth and exacerbate vulnerabilities, increasing the risk of a disorderly adjustment, stalling the convergence process, and adversely affecting the global economy," it said.
But what if policymakers can’t control the slowdown? A “hard landing”, where growth averages just 4pc a year until the end of the decade, would drag UK GDP growth down to 2.4pc in 2015, 2pc next year and 2.1pc in 2017, according to Oxford Economics.
The disinflationary forces unleashed by a hard landing would push UK inflation to an average of just 0.2pc this year, rising to 0.9pc in 2016 and 1.3pc in 2017. Inflation would remain well below the Bank of England’s target in 2018.
Where does this leave interest rates?
Raising interest rates after the crisis has proven to be tricky. According to RBS, all 15 central banks in the OECD that have hiked rates since 2008 have all subsequently been forced to cut.
Under government pressure, Turkey reversed course four months after it tightened policy at the start of 2014. Even Canada, which under the stewardship of Mark Carney became the first G7 nation to raise rates post-crisis, has been forced to cut them twice this year after the oil price collapse.
According to Oxford Economics, Carney, who is now Governor of the Bank of England, wouldn’t even get the chance to raise rates if China’s economy collapsed. Instead, policymakers would have to cut rates by a quarter of a percentage point to ward off the danger of low inflation becoming entrenched.
Under this scenario, the Bank would not lift rates back to their current record low of 0.5pc until the end of 2017. “We think that a hard landing for the Chinese economy would rule out a rise in Bank Rate, not just this year but also in 2016,” says Beck. “Indeed … the Bank may well be compelled to cut interest rates to try and offset disinflationary forces emanating from the East.”
However, Beck highlights that a sharper slowdown could also deliver benefits through cheaper commodities and a looser monetary policy.”
Five things to watch
Carney has mentioned five indicators that the Bank will watch closely: wage growth, productivity, core inflation, import prices and risks to the international environment. While international risks are likely to be top of the agenda at September’s interest rate meeting, other indicators suggest the UK economy is growing nicely.
Kristin Forbes, who also sits on the Monetary Policy Committee, recently noted that real pay growth in the private sector had increased at the fastest pace since 2007.
August’s Inflation Report also suggested the drag from falls in food and energy would “diminish” over the second half of the year, bringing domestic drivers of inflation into sharper focus.
There is also the impact of a stronger pound. Investec describes its recent rise as “unrelenting”. Bank policymakers have noted that the 6pc rise in sterling in trade-weighted terms this year is likely to bear down on inflation for “some time to come”.
However, Investec says the fact that 19pc of the pound’s effective index is now made up of emerging market currencies, including the Malaysian ringgit, Russian rouble and Chinese renminbi, which have appreciated by 20pc, 13pc and 2.3pc respectively since the start of the year, suggests that sterling could rise to levels that makes it much harder to return inflation to target.
In other words, with inflation not expected to get to 2pc until the end of 2017, even before warning lights started flashing over the Chinese economy, Threadneedle Street policymakers may have to sit on their hands for even longer.
No comments:
Post a Comment
Comments always welcome!