Paul Krugman is among those starting to be concerned about an economic downturn in China. Here are my thoughts on this issue.
Let me begin by clarifying that I am not reacting to the recent modest slowdown in China’s growth rates. If the issue is whether China’s real GDP is “only” going to grow at a stunning 7% rate, there’s not much to be concerned about. What rings alarm bells for me is the recent sharp spikes in interbank lending rates. Despite the official explanations, such moves could definitely be signaling some financial fragility.
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Suppose that those of us now worried that China’s Ponzi bicycle is hitting a brick wall (or, as some readers have suggested, a BRIC wall) are right. How much should the rest of the world worry, and why?
I’d group this under three headings:
1. “Mechanical” linkages via exports, which are surprisingly small.
2. Commodity prices, which could be a bigger deal.
3. Politics and international stability, which involves some serious risks.
To Paul’s list, I would add a fourth: financial linkages. If there are significant disruptions to China’s system for funding credit, that could have implications for anyone borrowing from or lending to Chinese entities. On the former, I am not sure of the foreign exposure for example to loans collateralized by nonexistent exports. On the latter, I think a strong case can be made that rising interest rates in China have been one reason for higher mortgage rates in the U.S.. In any case, it may be a mistake in the world of modern global finance to assume that what happens in China, stays in China.
I’d also like to add an observation to Paul’s second point involving commodity prices. A significant economic downturn in China could well mean a collapse in oil prices. One would think that, as a net importer, this would be an overall favorable development for the United States, and certainly it would be a significant plus for many individual U.S. firms and producers. But it’s worth remembering what happened after the collapse in oil prices in 1986. In the years leading up to that, just as today, there had been a dramatic economic boom in the U.S. oil-producing states, as oil producers invested heavily in more expensive projects. When oil prices collapsed, domestic producers took a significant hit. The labor and capital that had specialized for that sector can not costlessly move to other regions and activities.
It’s interesting to see for example what happens when you apply the recession-recognition algorithm that Econbrowser regularly updates for the U.S. economy to data for employment growth in individual states. I did this exercise as part of the background research for a study I conducted with Michael Owyang of the Federal Reserve Bank of St. Louis that recently appeared in the Review of Economics and Statistics (working paper version here). The graph below cycles through the inference for each state as we move from the first quarter of 1984 through the second quarter of 1987. Dark blue indicates strong evidence of expansion in that state for the indicated quarter, while the brighter the shade of green, the stronger is the statistical confidence that the indicated state was in recession at that time. Plunging oil prices were good news for much of the nation, but sent the U.S. oil-producing states and their neighbors into their own regional recession. This also contributed to the savings and loan crisis that the U.S. experienced at the time.
My bottom line: China is worth watching.
I’m less worried about Chinese financial fragility because of the Japanese example: an aging population that has peaked in size, industries under significant pressure from rivals, no natural resources to speak of, etc. And yet Japan has managed with ridiculous credit issues. I’m not saying it’s been great: the credit overhangs have been a real factor in Japan’s slow performance. But Japan has done more to modernize much of its productive capacity – which pumping vast sums into infrastructure – than the US.
There are obviously things to worry about but the underlying factors are so complex it’s impossible to forecast except by guess and luck which factors really matter. Consider for example that the PLA and the Party are themselves huge investors … and presumably are best placed to act as shock absorbers. One observation is that Chinese market activity seems backed partly by “western” finance and partly by non-Western, meaning quasi-state methods. I don’t know details of deals but I can’t imagine financing the world’s largest building using Western underwriting, but that kind of thing can make sense if the underwriting includes groups like the PLA. Then it becomes more like the rationale behind the entirely speculative development of Dubai and other similar little Gulf states. We even saw that with Dubai when Abu Dhabi stepped in to keep order.
Note that we saw a substantial increase in Global Net Exports of oil (GNE*) from 2002 to 2005, in response to annual Brent crude oil prices more than doubling, from $25 in 2002 to $55 in 2005. GNE rose from 38.7 mbpd (million barrels per day, total petroleum liquids + other liquids) in 2002 to 45.5 mbpd in 2005. At this rate of increase, GNE would have been up to about 66.4 mbpd in 2012 (versus the actual 2012 rate of 43.9 mbpd).
As annual Brent prices doubled again, from $55 in 2005 to $112 in 2012 (with one year over year decline in 2009), GNE have been below the 2005 rate of 45.5 mbpd for seven straight years (EIA).
As noted, we did see a year over year decline in annual Brent prices, from 2008 to 2009, but the annual Brent price fell to $62 in 2009, which was more than twice the previous year over year decline, in 2001.
Here are the three year over year declines in annual Brent crude oil prices since 1997, along with the rates of change since the 1998 low:
1998: $13
2001: $25 (+22%/year)
2009: $62 (+11%/year)
If the 2013 annual Brent crude oil price declines to the current price of about $108, this would be a +14%/year rate of change, relative to the $62 price in 2009, which would be between the 1998 to 2001 and 2001 to 2009 rates of change.
Whenever it happens, I suspect that the next year over year decline in annual Brent prices will result in a price that will be between 11%/year to 22%/year higher than the $62 annual price that we saw in 2009.
Of course, the key driver behind the 10 year increase in annual Brent crude oil prices, from $25 in 2002 to $112 in 2012 was the fact that the Chindia region was consuming an increasing share of GNE. Or, if we express it as the ratio of GNE to Chindia’s Net Imports, the GNE/CNI ratio fell from 11.9 in 2002 to 5.0 in 2012. At the 2005 to 2012 rate of decline in the GNE/CNI ratio (9.5 to 5.0), the Chindia region alone would theoretically consume 100% of GNE in only 17 years.
Of course, I think that we can all agree that the Chindia region will not be consuming 100% of Global Net Exports of oil in 2030, and the question is how and why it won’t happen. The most likely scenario is at least a slowdown in the rate of decline in Chindia’s demand.
On the other hand, the Chindia region is just the leading example of increasing demand in developing countries.
In any case, I expect to see a continuing cyclical pattern of higher annual highs and higher annual lows in crude oil prices.
Thanks for the post. Financial linkages will be one to watch.
A slight quibble with the bit on oil prices. I think a fall in price of oil would be a significant benefit to the U.S. Economy through terms of trade channel. Yes it’s important to emphasize that there will be different winners and losers, and losses would me more concentrated (hello North Dakota). But thats why we do economics on the margin and I think it stands to reasons that the net benefits to the U.S. economy from a fall in the price of oil would be fairly significant.
It would be nice to have an edit function. The following paragraph should read as follows:
Note that Available Net Exports (ANE), what I define as GNE less CNI (Chindia’s Net Imports), fell from 40.7 mbpd in 2005 to 34.9 mbpd in 2012.
How about a worrisome fifth linkage that is related to Krugman’s third linkage: China embraces military Keynesianism.
I am no Brad Setser but regarding the rising rates in China in June and the impact on US mortgage rates, we will know a bit more with the release of the TIC data next month.
If your theory is correct, we should observe a big fall in net purchases from China
Rather than a driver of the world economy China is a follower. If we look to China, it should be only as an indicator of the greater health of the more advanced economies of the world. China’s growth is driven by exports. Contrary to the thinkning of many devaluationists, a country cannot increase its exports by itself, there must be markets, demand.
China’s decline in production will impact oil supplies but, contrary to the opinion of some, lower oil prices will not generate much additional production in the advanced economies. Higher inventories of oil and lower prices are more a reflection of economic stagnation.
Professor, thanks for the discussion of the late 1980s “oil” depression. Many people do not seem to remember the serious implications of the decline. It takes years to bring productive sources of oil on line but only moments to close them down. Government mistakes such as those leading to the problems with oil in the late 1980s and in the late 1990s both brought a reversal of growing economies. It is not a pretty thought to consider the impact such government mistakes will have when the world economy is in stagnation as it is today.
I’m a huge fan of Krugman generally, but I still am not seeing any serious reason to believe China is about to implode or head for a crash landing. I thought mostly they did a very competent job handling the 2009 recession, when their export markets collapsed overnight and they had a very large fiscal stimulus relative to the US. When their economy recovered, they withdrew their stimulus in a suitable manner, unlike in the US, where we were stupid, went with a smaller stimulus, and then withdrew it prematurely.
Plus, if China does go in for a hard landing, and commodity prices collapse, I think this will be good for the US overall. My logic is that inflation will fall and the Fed will be more likely to stimulate the economy/not withdrawal stimulus too soon.
Prof. Hamilton – any chance of reassessing pension issues in California (or even just in San Diego as you did in 2007). Underfunding pension programs is one of our more scary unsustainable trends. On our current track, and assuming real returns perhaps similar to treasuries, when does CA hit the wall? Thanks!
http://online.wsj.com/article/SB10001424127887323829104578624010648228142.html?mod=WSJ_article_comments#articleTabs%3Darticle
WSJ: China’s Bad Earth
(Behind a paywall, but you might find it by doing a Google Search for: China’s Bad Earth)
Industrialization has turned much of the Chinese countryside into an environmental disaster zone, threatening not only the food supply but the legitimacy of the regime itself.
I am less worried about China now that the US stock market is at an all-time high and that the European Central Bank has back stopped financial concerns since the middle of 2012. It is certainly less of a concern now than it was a year or two years ago. However, we have to remember that he is interested in keeping the spigot open in China, the US, and Europe. That is his main objective and a valid viewpoint. He certainly argues it with style and wittingly.
The inestimable Amrita Sen on China’s oil outlook:
http://www.energyaspects.com/publications/view/china-the-great-rebalancing?utm_medium=email&utm_source=weeklyemail
Here’s the sort of analysis to which I refer above. But we could use a lot more along these lines.
http://www.baldingsworld.com/2013/07/26/this-time-is-different-with-chinese-characteristics/
And now this:
“Forget growth, China is contracting, experts say”
http://www.cnbc.com/id/100921496
I am not convinced that Wolff articulates his case particularly well, but it’s more pessimism on China.
China and Hong Kong take about 10% of most western developed country exports and much bigger shares of Japan’s, Australia’s and global EM exports. Those are just the direct mechanical linkages. How that adds up to “surprisingly small” in Krugman’s mind is hard to fathom.
James
How big is the GDP of oil rich states in the USA though?
Texas is clearly pretty important– but not wholly dependent on oil prices (and Texans are also famous *drivers* and of less fuel efficient pickups and SUVs. The farm sector for example is a big user of fuel, and so are railways).
My thought is the gains to non oil states, many of which have quite big GDPs (California!) as well as high driving dependency, would offset the shrinkage in the oil and oil services sector?