China and the Long March to (Global) Recovery

The unfolding bi-polar global economy emerged this week with talk of “green shoots” in the US being mimicked by “bamboo shoots” in China. Several leading indicators from stocks, housing and credit markets had some hoping that these were early signs of recovery. This was then dashed with reports of poorer than expected retail spending in the US and weaker GDP growth in China later in the week. Closer inspection of China's data however show that there were genuine signs of recovery burried in the figures.

The Economist rightly points out that the slowdown in China is a result of purposeful policy back in 2007 when authorities were worried of overheating and restricted the flow of credit. The recent data shows that lending and investments have been restored, and that consumer spending has remained robust (read Jim O'Neill from Goldman Sachs referring to China as the new shopping superpower here). What has been impeding growth overall is the slowdown in exports resulting from weak demand from abroad. Contrary to perception though, employment in the tradable sectors accounts for only 10% of the labour force and much of the content of their exports is imported from abroad (only about 18% is locally value added, which translates to 7.2% of GDP).

Andrew Peaple of Dow Jones writes in the Wall Street Journal that:

the debate among economists is becoming more alphabetical. Is this recovery V-shaped, with China set to return quickly to the high-level growth of recent years? Or is it more W-shaped, as a government spending-led recovery this year peters out and China's longer term structural issues resurface?

Manoj Pradhan of Morgan Stanley forecasts that:

(G)lobal output will probably start growing in 3Q09 (3rd quarter of 2009), with G10 output growth turning positive in 4Q (4th quarter). However, growth for 2009 as a whole will stay firmly in negative territory for all regions except AXJ (Asia excluding Japan) ... We expect AXJ’s outperformance to be sustained next year with a 6.4% increase in output, compared to 2.1% for CEEMEA (Central and Eastern Europe and Middle East and Africa), 1.1% for the G10 and 0.3% for Latam (Latin America).

That developing Asia will lead the world to recovery is evident from this forecast as well as by consulting this year-to-date chart of stock market performance around the world assembled by Bespoke Investments. Apparently, there could still be something to the BRICs and decoupling argument after all.

The Impact of China's Stimulus

Markets cheered when the leaders of the G20 emerged from their summit in London with little more than an agreement to infuse the IMF with additional capital through issuing SDRs (special drawing rights) intended for distribution among member countries. Dani Rodrik points out the significance of these measures.

To produce greater bang for each buck from a fiscal stimulus plan, countries have to increase their Keynesian multiplier. One of the things that reduces the multiplier effect is the marginal propensity to import. To prevent leakage of such spending on foreign goods (the effect of the marginal propensity to import), it is essential for other countries to "pull their weight" and engage in similar levels of spending. In developing markets, credit and liquidity was drying up, limiting their capacity for fiscal spending .

This is why the Chinese fiscal stimulus which is roughly equivalent to 90% of Australia's entire GDP was significant for advanced economies. Some estimates put the multiplier in China at 1.1, meaning $1 spent by the government leads to $1.1 of additional spending elsewhere. Picture the output of Australia for two years being disbursed in less than a year. Much of this multiplier is due to the public investment nature of the spending on roads and basic infrastructure. For this reason, resource rich countries like Australia will have much to cheer about in the coming months.

The death of BRICs and decoupling?

The announcement by China of a 4 trillion yuan stimulus package (approaching the size of the entire Australian economy) has provided the clearest signal that the BRICs theory could be coming to an end and with it the idea of decoupling.

The BRICs Dream

It was in the wake of events in Septemeber of 2001 that investors searched for ways to spread risk and rebalance their portfolios heavily weighted towards advanced markets. Jim O’Neill, an economist at Goldman Sachs, in a paper entitled Dreaming with BRICs coined the now ubiquitous term and created with it the theory of decoupling: the notion that European and emerging economies, such as Brazil, Russia, India and China (BRICs), have diversified and deepened enough to sustain growth during economic downturns in the US.

From 2003 to 2007 the idea was holding up pretty well. The rapid climb of the BRICs was breathtaking. The world economic tables compiled by Angus Maddison gave a stunning picture of the “arc” that China in particular was following in its industrialization. Germany and Japan were notching up respectable growth figures at last. The US economy was well on its way to full recovery with a series of tax cuts and low interest rates. Things were looking pretty solid.

Repricing

Then as the first wave of repricing of sub-prime mortgages began in late 2007, things began to unravel quickly. Global fund managers and banks in a synchronized manner started to re-examine, declare and write-down their exposures linked to these mortgages.

At the annual World Economic Forum in Davos, Switzerland, CNN’s Richard Quest began polling participants on their views regarding the possible contagion effect the US housing crisis would have on the rest of the world. Those who projected a slowdown edged out the doom sayers who saw a prolonged recession.

At the conclusion of the forum, the International Herald Tribune ran a piece called Decoupling: Theory vs. Reality. The message was that only a partial decoupling had occurred. As America sneezed, Europe would not catch a fever, just a mild cold, neither would Asia contract pneumonia, just the flu. This prognosis rested on the case that China could not substitute fully domestic consumption for lost exports and that investors had oversubscribed Chinese shares in the five years since the BRICs Dream came out.

The IMF as late as June of this year, released a study called Convergence or Decoupling supporting the notion that decoupling and integration could actually occur simultaneously. From 1985, globalization has brought about greater integration and increasing finance and trade flows among countries. This has led to the coupling of business cycles among countries with similar levels of per capita income, but evidence of decoupling for groups of countries at various stages of development was also found.

Then the September surprise on Wall Street hit beginning with Merrill Lynch, Lehman Brothers, and AIG. Synchronous market gyrations, recession stalking a number of EU members followed by the slowing of Chinese and Indian growth prospects have all but eclipsed the decoupling thesis. A briefing paper entitled Synchronised Dive into Recession prepared by the International Economics Programme of the UK-based think tank Chatham House in October has said:

(u)p to mid-2008, the emerging markets remained strong – ‘decoupling’ did work. Now the crisis has deepened, no region will remain immune to shock waves.

In other words, all bets are off!