AS Chinese economic data early last week showed the world’s second-largest economy continuing to slow, gloom and doom once again pervaded financial markets. Major equity indices fell sharply, currencies continued to be volatile and forecasters hurried to downgrade the outlook. As this was happening, it turned out that South Korean exports had fallen sharply in August — since South Korea is a major trading nation, this was not good news for the world economy. Consequently, Christine Lagarde, managing director of the International Monetary Fund (IMF), has warned that global growth will remain moderate and perhaps even weaken more than the IMF had forecast as recently as July.
But are things really all that bad in the global economy?
A closer look at the data and the forces underlying the global economy suggests that a less alarmist view should be considered. The emerging rebounds in the G3 economies of the US, Europe and Japan unfolded despite the Chinese slowdown — and are likely to continue. It is true, though, that economic activity in China could slow further and pose greater risks to the world economy. But, the net impact on Asia of an expanding G3, which accounts for almost half of global GDP versus a decelerating China, is likely to be positive.
The G3 is rebounding, led by the US
Since the data can be very volatile from month to month, we need to look at the overall trends in the US, Europe and Japan. These show a gathering rebound underway:
• The US is particularly strong. GDP growth in the second quarter surprised positively, growing 3.7% q-o-q annualised, up from 0.6% in 1Q2015. The housing sector is picking up, with new home sales rising strongly. This is boosting construction spending, which has been expanding strongly for four months in a row. Consequently, indices of consumer confidence such as the Conference Board Consumer Confidence Index are rising. In fact, sales of vehicles rose to a new post-crisis high in August. The manufacturing sector, however, appears to be losing some verve in the third quarter, but this was expected and is a product of the excessive build-up of inventories in the first half and the impact of the strong US dollar. This does not worry us because the manufacturing sector represents just 12% of US GDP; the services sector is the key and it is doing well. Moreover, there are early signs of life in investment spending which could really boost growth: Core capital goods orders rose 2.2% m-o-m in July, its best showing this year. The fact that spending on intellectual property surged 8.6% q-o-q in the second quarter, at the most robust pace since 4Q2007, suggests to us that something very powerful could be stirring in this vital sector.
• Europe is also turning around. Purchasing manager indices showed economic activity continuing to recover in August while unemployment fell to a 3½-year low; and
• Japan is regaining momentum. The lead indicator is rising again while robust corporate profits (up a solid 23.8% in the second quarter) seems to be supporting a pickup in capital spending. Housing starts are also bouncing up, a positive sign for high-multiplier construction activity.
This is not all: There are two forces that could help reinforce this recovery. First, oil prices have fallen further in the past month, providing these economies with the equivalent of a huge boost to spending power. Second, note the tantalising — but early — signs of a recovery in capital spending in both the US and Japan, which could mean that the missing ingredient in the G3 recovery could be returning — investment in the rich countries is still about 5% below the peak reached in 1Q2008, just before the global financial crisis erupted in full force, so there is scope for a good rebound.
What about China?
There is simply no doubt that China’s economy is in poor shape and things will get worse.
Surveys of purchasing managers in China paint a discouraging picture about the manufacturing sector. It is not just that overall activity levels are falling. The details in these reports suggest that things could get worse:
• First, new orders are weakening — for both domestic and export demand; and
• Second, production continues to increase despite the fall in orders, which means inventories will grow, and the eventual cutback in production will have to be abrupt.
The Organisation for Economic Co-operation and Development’s lead indicator for Chinese growth confirms a cautious outlook, indicating that growth will be well below trend. Looking beyond China data to international data on import volumes around the world, we get an even more worrisome picture of China. When data on Chinese imports is corrected for the effects of falling commodity and other prices, what we find is that Chinese import volumes, which were growing nicely throughout 2014, collapsed in 1Q2015 and fell further in the second quarter. While detailed data on which items contributed to the collapse in import volumes is not available, our checks suggest that the cause was not a decline in the volume of primary commodities. Indeed, imports of oil rose sharply as China took advantage of low prices to add to its strategic reserve.
The more likely cause of this large and unprecedented fall in import volumes seems to be capital goods imports. If that is true, it suggests that investment spending must be declining — a potentially catastrophic development in an economy where investment accounted for about 47% of GDP. Some say signs of recovery in the real estate sector mean property-related investment could recover. This is overly optimistic — with so much excess supply of housing, any recovery in new construction is going to be patchy and uneven. Also, even if the government can press state enterprises to maintain their investment levels, investment will still struggle to support overall growth.
Moreover, data has emerged on the worsening plight of the corporate sector. Industrial company profits in July fell 2.9% y-o-y, sharply down from the 0.3% y-o-y decline in June. Not surprisingly, the banks that lend to these corporates are suffering: Several have just reported their second quarter results, which show a sharp acceleration in non-performing loans and mediocre gains in profitability.
So, what is the net impact on Asian economies?
First, the upside from the rising momentum in the G3 economies (50% of total world output) should offset the deceleration in China, which accounts for 13% of global output. The impact of much lower oil prices will accentuate this effect — and if US and Japanese capital spending really does recover, with its high multiplier impact, the recovery will turn into a much stronger surge. Note that even with the sharp decline in Chinese import volumes in 1H2015, overall global import volumes continued to rise.
Second, if we assume that Chinese economic growth sinks further, to the 3% to 4% in actuality that we expect (whatever the official data shows), there will be several channels of transmission:
• Chinese imports from the rest of the world would fall further. To ascertain the impact on economic growth, we need to look at global value chains rather than the raw trade data. This value chain analysis isolates the value created by trade with a country and suggests that the big losers from a further slowdown in China would be Taiwan, South Korea, Japan, the Philippines and Hong Kong. India will be barely affected. Within Asean, Vietnam, Thailand, Singapore and Indonesia are less affected, whereas Malaysia is in between;
• Commodity prices might be further depressed. Commodity prices have already fallen significantly, however, in anticipation of difficulties in the Chinese economy. So, the fall in prices of oil, coal, base metals, rubber and other raw materials used in industrial processes may not be huge. The fall in oil will hurt Malaysia while depressed coal prices are negative for Indonesia. Outside these, Asean countries are likely to be less affected, as their commodity exports are mainly in the food area such as crude palm oil, rice, seafood and coffee, commodities less affected by global economic cycles. In fact, if declining energy and raw material prices made manufacturing more profitable, the resulting expansion of global trade would boost Asean;
• More destabilising capital flows? An even worse outcome for China than is priced into markets could prompt another deluge of outflows from emerging markets, putting further pressure on countries such as Malaysia and Indonesia. In this case, however, we expect the US Federal Reserve to hold off from raising rates while it is almost certain that regional central banks would ease monetary policy more aggressively. The net effect may not be so negative, particularly
as so much bad news is already in the price; and
• Deflationary trends could be reinforced. There are signs that Chinese producers of industrial goods that are struggling with massive excess capacity and growing inventories are exporting this surplus at much lower prices. Intensifying deflation is not good news in a world where debt levels have grown — the real value of debt repayments would become onerous. We could also see a rising clamour for more protectionism if China exported its excess capacity in this fashion.
Conclusion: Things are not so bad for Asean
So, yes, we should belt up for a rough ride as China slows. But the G3 recovery is unlikely to be derailed by China and that recovery will help offset much of the negatives for Asean. We should not be too pessimistic about Asean’s prospects — so long as domestic political and economic fundamentals are maintained.
Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy
This article first appeared in Opinion, digitaledge Weekly, on September 7 - 13, 2015.