Paul Armstrong-Taylor is Resident Professor of International Economics at the Hopkins-Nanjing Center and author of the forthcoming paper ‘Effects of Trade and Financial Links on Transmission of Economic Growth’ in the journal Frontiers of Economics in China.
Earlier this year a RMB3 billion (US$487 million) trust fund issued by China Credit Trust Co. and marketed to customers at Industrial and Commercial Bank of China threatened to default. Though in the end investors did not suffer significant losses, the episode highlighted the riskiness of the rapid growth in trusts and wealth management products in China. A related and long-running concern of the China bears is the real estate sector. Construction is important for GDP and employment, but it is also connected to several other vulnerable sectors. Construction companies have been major beneficiaries of shadow bank lending; furthermore, construction is a major source of demand for producers of steel and concrete (many of which are already struggling with capacity) and land (sales of which underpin the budgets of many local governments). Financial firms, policymakers and increasingly the popular media have warned that a crisis in China’s shadow banking or real estate sectors could pose a threat to the global economy – that it could even represent another “Lehman moment.”
There are some reasons why these fears may be overstated. Most bullish commentators have focused on the possibilities of containing any crisis domestically. For example, although it has grown rapidly, China’s shadow banking sector is still relatively small at 30% of bank assets (compared to 170% in the US). While real estate prices have increased sharply, incomes have mostly kept pace and demand, at least in first-tier cities, seems solid. Compared to most countries, the Chinese government has plentiful resources and tools to combat any crisis. For example, it can directly influence bank lending in a way that governments in developed countries cannot.
Even if China does avoid a crisis, it appears inevitable that growth will have to slow as it transitions to a more sustainable growth model. This too has caused concern that China may cease to be the engine of global growth. However, my recent research suggests that the world has little to fear from a slowdown in the Chinese economy. There are two main channels through which economic shocks can be transmitted between countries: Trade and finance. Let us consider each in turn.
One might expect that growth in trading countries such as China would have a bigger effect on other countries than countries that trade little. In fact, historically, openness has no statistically significant relationship with the transmission of growth internationally. However, the trade balance does matter: Growth in deficit countries affects other countries more than that in surplus countries.
How do we explain this? Exports are driven by foreign demand, so there is no reason to suppose that that demand would automatically decline if a country suffered a domestic recession. However, imports would probably fall and this would hurt foreign exporters and overseas growth. We would expect this effect to be particularly strong during a global recession when demand is most scarce. This is indeed what we see in the data.
Although China trades a lot, it runs a surplus. Furthermore, many of China’s imports are supplies for their exports. If exports are not hit, there is no reason to suppose these imports would fall. For both these reasons, an economic slowdown in China may not have much effect on the rest of the world via trade.
How about finance? If we look at the historical data, we find that finance is a more significant channel for the transmission of economic growth than trade. The effect is particularly strong during times of economic crisis (such as the period after the 2008 subprime crisis), and has been growing stronger over time as the financial world becomes more integrated. For example, when the market in mortgage backed securities in the US collapsed after 2008, German Landesbanks, regionally organized lenders mainly involvedin wholesale banking, were found to have large exposure to such assets, which necessitated government bailouts.
China is much more closed to finance than trade. While banks in most developed countries have significant international exposure, Chinese banks are almost exclusively domestic. This is partly the result of regulations that limit foreign participation in China’s financial sector, the limited convertibility of the renminbi and a focus on providing services to domestic state-owned enterprises. This financial isolation may have costs for the Chinese economy (something the government seems eager to address with proposed reforms), but it also provides protection from foreign economic problems. This was one of the reasons China was relatively unscathed by the Asian Financial Crisis in 1997 and subprime crises in 2008. The reverse is also likely to be true. Foreigners have little financial exposure to the Chinese financial system and so a crisis in China is unlikely to spread by the financial channel.
There is recent precedent to support this view. Japan suffered a major financial and real estate crisis in 1990 that led to a sharp slowing of growth. At the time, it was the second-largest economy in the world, and a major trading nation. Despite this, the Japanese crisis was largely a domestic affair with little contagion to other economies. China today is in some respects similar to Japan in the 1990s, but with a much more closed financial system. Whether China’s growth slows suddenly (as a result of a crisis) or gradually (as part of a transition to a new growth model) the global economy will probably be fine.