For the past year and a half or so, the focus of the global economy has undoubtedly been on China. Consumption and services remain strong and look set to offset the slowdown in industrials and manufacturing in the long term. But in the short term, things are slowing down. Now that the Chinese growth engine is slowing, the follow-up question becomes how much will the rest of the world get affected by this development. There are a few channels through which a Chinese hard landing can spread to the rest of the world, with the key being the trade channel.
The Rise of Chinese Trade
In 2001, China gained access to the WTO, a milestone which marked its integration into the world economy. Since then, Chinese labor, foreign investment and the global market have combined to turn China into a major export powerhouse.
Along with their share in trade, China's FDI also surged post 2001. This was the result of the Chinese government lifting trade barriers (as part of the WTO accession), creating a more open domestic market to foreign companies, which led to heavy FDI inflow.
As China's share of the global trade rose, so did the world's dependence on Chinese demand. As a result, the key transmission channel through which a Chinese slowdown could spread through to the rest of the economy is through trade linkages, both direct and indirect. Trade is key because China is the largest global exporter and the second largest global importer. China's large share of world trade has expanded in recent years to as much as 14.3% in 2013. In terms of global GDP, China has also increasingly become a major contributor with 13.3% of world GDP vs. 23.7% by the EU and 22.4% by the US.
China typically dominates in "old economy" industries such as machinery, textiles and telecom equipment. For instance, China dominates the global export share of computer equipment (>56%) and plastic toys (>65%). China's export dominance also covers breadth, with ~10% global export share in one-third of all product categories, according to Comtrade. However, Chinese labor costs have been rising and eroding the competitiveness of labor intensive exports.
As a result, we are seeing labor intensive export share, such as textile and footwear, drop from 25% in 2000 to 15% in 2014. As domestic value-add rises, there has been a shift away from labor intensive exports toward hi-tech exports, as their share rose from 15% to 28% from 2000 to 2014. Machinery and transport equipment continue to dominate share of total Chinese exports but has fluctuated around 48% in recent history.
Trade Channel Effects
The trade channel effects alone emanating from China has been enough to trim global GDP significantly and further compound the secular stagnation problem. Looking at countries with the largest direct trade exposure to China, Korea and the Netherlands stand out as the most exposed. However, direct trade linkages alone does not provide an accurate picture of the possible magnitude of trade channel effects on global GDP growth. Take the Netherlands for instance. Most Dutch exports to China are really re-exports through Dutch ports, constituting low value-add and can therefore make gauging the trade impact misleading.
Indirect links, on the other hand, have the bigger impact. This comes through more of a domino effect as global trade is inherently linked. Even countries that import or export nothing from China can be affected, as their trade partners are likely to be dependent on the Chinese economy. In other words, global trade is inherently linked. Weakness in one link spreads to the next link, gets magnified and can eventually lead to a systemic crisis.
Rebalancing Driving Trade Deceleration
We are certainly seeing evidence of the domino effect today as China transitions from the "old" industrial driven economy to a "new" consumption driven one. The effect of this transition is evident today in the "old" economy's slowdown. The heavy investment and credit used to fuel the industrial boom that drove China's growth miracle over the past few years has now resulted in overcapacity and deflation.
Now that rebalancing is underway, growth numbers have taken hit as GDP growth slows from over 7% (government's target at 7%) to a slower, more sustainable 6.5%. Recent data has supported this trend with overall GDP growth slowing to 6.8% in real terms and 6.0% in nominal terms.
The heavy investment was originally used to fuel the rapid buildup in capacity (especially in construction and traditional manufacturing) to accommodate growth. However, now that China is moving away from industrials and manufacturing to consumption and services, this has resulted in an overcapacity problem in China which has in turn led to a cutback in investment and abandoned factories galore.
Now, moving away from an investment driven economy spells much doom and gloom for the world economy as investments have a much higher import content than consumption, particularly in "old" economy industries involving commodities and machinery.
According to Xinhua, Chinese steel production, for instance, will slash 400,000 jobs in line with its planned cut in steel production capacity by 100-150m tonnes. However, 400,000 job cuts mean far more if you connect the dots. If every worker in the Chinese steel industry supports 2-3 additional jobs, this could actually add up to an overall loss of 1.2-1.6 million jobs.
Not good for the politicians, considering the growing threat of social instability in China.
The investment led 7+% growth seen by China over the past few years was always unsustainable. While the growth numbers are certainly sky high, the poor quality of growth generated by the Chinese was bound to catch up at some point. Evidence of this poor growth is perhaps best characterized by the productivity numbers. Productivity has only accounted for a measly 5.7 percentage points of growth since 2008, with the rest being generated by investment.
Unfortunately, China's heavy reliance on investment has come at a price. Debt has reached unprecedented levels, soaring to 282% of GDP while other forms of capital have also been depleted.
As China rebalances, the overcapacity problem should eventually ease and growth will be more balanced and sustainable. However, that shift will come at the price of shrinking global trade as one of the world's key growth engines sputters along at 6.5%.
One Belt, One Road
In fact, China has been taking advantage of its status as a net oil importer to correct internal imbalances and export the excess capacity which has been deflating producer prices and dragging down the economy. This is taking shape through President Xi's New Silk Road program consisting of major infrastructure buildout, including roads, railways, pipelines and ports from Xian to Athens, as commodities and building prices continue on their downward spiral. The overarching goal of the program is to build infrastructure facilities to improve collaboration and integration of the Eurasian countries covering six economic corridors - 1) China-Mongolia-Russia Economic Corridor, 2) New Eurasia Land Bridge Economic Corridor, 3) China-Central Asia-West Asia Economic Corridor, 4) China-Indochina Peninsula Economic Corridor (ASEAN), 5) Bangladesh-China-India-Myanmar Economic Corridor, and 6) China-Pakistan Economic Corridor
The 65 countries covered by the OBOR economic belt contributed 29% of global GDP in 2013 and should become the global economic growth engine of the future. By building influence over this belt, China aims to rejuvenate growth in the face of slowing growth from a structural shift towards consumption. Through the OBOR, China can facilitate bilateral trade and gain an outlet to export excess capacity.
Consequently, in the early stage of the OBOR development, infrastructure and railway equipment companies will be the direct beneficiaries as China looks to remove transportation bottlenecks. The One Belt, One Road (OBOR) initiative stands to gain massively as a result as commodity dependent producers along the route look to diversify through the $40bn Silk Road infrastructure fund. China stands to benefit negotiating from a position of greater strength as the OBOR becomes more financially viable as a result. Through OBOR projects like the $5.5bn high speed train in Indonesia and the $1.65bn dam project in Pakistan, China looks to assert its presence in the region.
As Chinese growth slows and the New Silk Road initiative begins to take shape, expect to see structural shifts begin to emerge in global trade as we move into a new Chinese normal. In the meantime, the rest of the world may simply have to live it.
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