What if China's economy tanks?
The Chinese housing bubble is at risk of bursting due to economic imbalances. If China's housing bubble bursts, a shockwave will reverberate through its economy, causing a dramatic slowdown that will spread around the world. Utilizing a powerful new simulation tool, we forecast how a "hard landing" for China would impact the global economy.
China's business climate is uncertain and growing more so by the day. Cheap credit and a ballooning shadow banking sector in the past few years drove a massive increase in new lending, which fueled a red-hot real estate market and excess construction. As the economy cooled, the massive housing supply ramp-up resulted in high vacancy rates in some Chinese cities, which led to steep price discounts on new properties and rising default rates among smaller property developers.
Global corporations are watching China closely, wondering what will happen next. If the situation were to spiral out of control, they must be able to evaluate the impact on their business quickly and make appropriate course corrections. For instance, what does a hard landing in China mean for interest rates, trade, capital investment, commodity prices, and consumer demand, not only in China but in Europe, India, the US, and elsewhere? The more variables they can control to simulate possible scenarios, the better prepared they will be to respond to the one that actually unfolds.
Using a new econometric simulation tool called the Global Link Model, IHS is able to quantify the impact of economic shocks and regulatory changes to test a wide range of scenarios on the global economy. The model includes 68 countries and is linked to sector-specific econometric models, enabling users to see how changes in the macro-economy impact sectors and companies, as well as how changes at the micro level influence overall economic developments.
This article examines the consequences of just one scenario: a hard landing in China and the impact it would have on both the Chinese economy and the global economy. We define a hard landing as annual GDP growth for China of less than 5%. See the table at the end of this article that captures the impact on GDP growth for 15 of the largest economies in the world.
What a hard landing would mean for China
The scenario starts with a severe tightening of credit in the formal banking system and the country's sizable shadow banking sector, accompanied by a downturn in the residential real estate market. The credit crunch significantly drags down investment growth, and the real estate recession severely reduces Chinese household wealth and consumption. The credit contraction also limits trade financing and, hence, exports. This widespread demand downturn hampers industrial production. As China's domestic demand slows, the yuan depreciates and imports decline, which directly impacts China's trading partners. One bright spot in this scenario is that global commodity prices would decline in response to reduced demand, slightly attenuating the negative effects of China's slowdown on the global economy. (See the six figures below.)
The timing of the bursting of the bubble in our scenario is set for the third quarter of this year. While the effects would start to be felt immediately, the most dramatic impact wouldn't occur until 2015. The six figures below left capture the devastating consequences of the hard-landing scenario on China's domestic economy. Annual GDP growth is forecast to decline to 4.8% in 2015, which is nearly three percentage points below the baseline scenario. China's GDP growth wouldn't recover fully to the baseline projection until 2018.
Likewise, fixed-investment growth is forecast to drop by 4.7% in 2015 to just 3%, compared with the baseline scenario; industrial production would drop by 3.6% from the baseline scenario. Both imports and exports would see sharp declines in growth rates, with imports experiencing their worst performance in 2016 and 2017.
Widespread global implications
Looking beyond China's borders, there are three primary channels through which China's economic downturn would be transmitted around the world: exchange rates, energy and commodity prices-both agricultural commodities and non-agricultural commodities-and international trade. Under our hard-landing scenario, the combination of these three transmission mechanisms is projected to shave a full 1% off the world's real GDP in 2016.
The yuan is forecast to depreciate by 5% as China's real GDP growth falls. This makes China's goods less expensive to other nations, but foreign goods become more expensive in China. So China's exports benefit but imports suffer. At the same time, slower growth in China causes international financial investors to shun emerging-markets risk, which puts pressure on the exchange rates of countries highly dependent on foreign capital inflows, such as India, Indonesia, and Turkey. This causes the depreciation of their currencies, making their exports cheaper and imports more expensive. This in turn contributes to both inflationary pressures and a slowing of their economies.
IHS estimates that at least nine nations would suffer currency depreciation if the yuan were to depreciate by 5%: Argentina, Australia, Brazil, Chile, Colombia, India, Indonesia, Mexico, and Turkey. In Indonesia, for example, the effect would be a dramatic rise in interest rates as the government tries to stem capital flight, negatively impacting investment. This would lead to a jump in consumer prices of close to 3% in 2016 as imports become more expensive due to the exchange rate depreciation.
China's hard-landing scenario would result in a slump in commodity prices worldwide as domestic demand slows. Key commodities impacted include aluminum, copper, iron ore, and zinc. This would be good news for countries that are net importers of these commodities and bad news for exporters. Potentially hardest hit would be the mineral-producing nations of Australia, Chile, and Indonesia.
While commodity prices and exchange rates are important, it's the consequences for international trade that would have the most immediate and severe impact on the global economy as a result of China's hard landing. China's economy accounts for approximately 12.5% of the world's total nominal GDP, so the trade impact would touch virtually every product type and country.
Countries with perhaps the broadest trade exposure to the risk are China's closest neighbors. For instance, Thailand is a key exporter to China in three of the four major categories of goods. It exports nearly 24% of its agricultural products, 16% of its manufactured goods, and 13% of its energy products (see figures below).
In the manufactured goods sector, eight of the top 10 exporting countries are in China's neighborhood, including Japan and South Korea. More than 20% of Japan's exports are shipped to China, including both commodities and manufactured goods. As a consequence, Japan would suffer a decline in overall export growth in 2016 of about 5%, compared to the country's baseline forecast. It would also suffer a drop in imports, a consequence of integrated supply chains within Asia.
Australia, Indonesia, and Malaysia would suffer similar consequences. Australia, for example, exports 48% of its non-agricultural commodity exports to China. The hard-landing scenario forecasts that Australia's real GDP would be significantly lower than the baseline forecasts in 2016 and 2017, respectively.
Of course, nations farther afield are vulnerable too. Chile is a major commodity-exporting nation and is vulnerable to a China hard-landing scenario. India exports nearly 80% of its non-agricultural goods to China. While not a significant component of India's total exports, it is projected to contribute to a 0.7% decline in India's real GDP in 2016. Similarly, Russia and the US export agricultural products to China, and Kuwait and Saudi Arabia export oil. All of these countries would see slower domestic economic growth in the next four years if the hard-landing scenario were to materialize.
In the US, the fall in exports would be expected to lead to slower employment and income growth. In response, the US Federal Reserve would likely keep interest rates low for longer than currently anticipated. The Global Link Model projects that US real GDP growth would diverge from the baseline projection by a half percentage point a year through 2018 (see figures below).
While this would slow the US recovery, it is a modest hit compared to many of the largest economies in the world. Specifically, Asia-Pacific economies such as Australia, Indonesia, Japan, Malaysia, and South Korea look to take the brunt of China's hard landing. Of course, China itself, where the shock wave originated, would be the hardest hit of all.