How severe a slump in China?

The US, UK, Eurozone and Japan all look to be in recessions. The US and Europe had been the main drivers of global demand growth – at least for finished goods. That is going to change.

Emerging economies that relied on a commodity windfall to support higher domestic spending and investment may also need to cut back. The windfall isn’t what it once was. That also will cut into demand.

Emerging economies that relied on borrowing from the rest of the world to support high levels of domestic spending and investment also will be cutting back. They have been hit by the credit crunch.

China benefits from lower commodity prices. It has no need to borrow from the rest of the world to support high levels of domestic investment.

The world economy could really use a Chinese locomotive. But it increasingly doesn’t look like it will get one. A recent Credit Suisse report noted that the latest purchasing managers survey suggests that China is about to enter a manufacturing recession. Export orders fell sharply – as one would expect. But import orders fell more. If that proves an accurate guide to China’s demand for the world’s goods and services, China won’t be doing much to support global growth.

There has long been a rather sterile -- at least in my view - debate over how much exports contributed to China’s recent growth. It has long been clear that:

a) Most of China’s growth didn’t come from exports. It couldn’t. Net exports almost never generate 10% growth on their own.

b) The absolute size of the contribution of net exports to China’s growth was large. In 2005, 2006 and 2007 net exports added between 2 and 3 percentage points to China’s growth. When net exports added close to 3 percentage points to the United States growth in the second quarter, no one argued that the contribution to US growth from net exports was small.

Net exports contributed positive to China’s growth in the first half of the year. The World Bank expects that net exports will contribute around one and a half (1.5) percentage points to China’s growth. Real export growth topped real import growth – though both slowed. 1.5% percentage points from net exports isn’t bad. It is more than the US had gotten on average over the last seven quarters. Indeed, it is not all that different from the average contribution net exports have made to US growth in 2008.

The Chinese exporters who were doing well just weren’t as vocal as the textile and toy producers who weren’t. They also tend to be more capital-intensive and thus employ fewer people.

And despite all the (true) talk about the difficulties some Chinese exporters now face, net exports almost certainly contributed positive to China’s growth in the third quarter. Real export growth in the third quarter (on a y/y basis) still exceeded real import growth. That is why China’s nominal trade surplus was basically flat during the first three quarters of 2008 even though China was paying way more for its commodity imports.

The sharp contraction in US consumption, the rise in the yuan v the euro, Europe’s own slowdown and the latest data from China suggests that real Chinese exports could soon fall. If net exports are contributing to growth, it will be from a fall in imports, not a rise in exports. That is sure to slow China’s growth.

Absent the close to 3% contribution from net exports in the boom years, China’s growth would have been a (respectable) 9% rather than above 11%. With a negative 3% contribution to growth during the boom (as is often the case), growth would have been close to 6%. And if net exports turn negative now China’s growth clearly would slow sharply.

But the real key to forecasting China’s future growth consequently is determining whether domestic consumption and above all investment will continue to grow strongly in the absence of strong export demand. Remember, over the past few years both domestic investment and exports increased rapidly. If they fall together as well, Chinese growth will slow quite significantly.

And unfortunately the latest indicators seem to suggest that they are correlated; consequently domestic demand may fall along with exports.

That isn’t good for anyone.

The (likely) fall in construction is particularly worrisome. China’s new capital intensive export sectors haven’t been huge job generators. Building buildings by contrast employs lots of people – including a lot of migrants from rural areas.

Chinese policy makers recognize that China’s economy is slowing. They are trying to stimulate the economy in a host of ways. Loan limits have been lifted (and amusingly, their presence was only formally acknowledged when they were lifted). New infrastructure projects have been announced. Useful (though tardy) steps are being taken to improve China’s social safety net. It just isn’t clear if they will be powerful enough to offset a smaller contribution from net exports and a (likely) slowdown in investment.

I should note that China is also taking steps to promote exports, notably by increasing its export rebates. That is far less helpful to the global economy.

If the signs from China continue to point to a sharp slowdown, all the large parts of the global economy may enter into a slump at the same time. That isn’t good.

A final point: it is often argued that China needs rapid growth in order to generate jobs, and consequently 6-8% growth doesn’t cut it. That is only partially true. A lot depends on the composition of growth. Recent Chinese growth has been capital not job intensive, so very rapid growth hasn’t translated into rapid job growth. If China shifted the basis of its growth, it might be able to generate more jobs even if the overall pace of growth changes. The risk though is that China won’t change the basis of its growth – so slower growth will mean fewer jobs. But we shouldn’t lose sight of the fact that it is unusual for a country growing at 5-6% not to be able to generate strong job growth.

Update: Yves Smith interpreted my post as a critique of Nouriel’s argument. That isn’t really the case. I wanted to avoid Roubini’s framing, which seemed to lend itself to a semantic debate over whether 6% growth is a hard landing or not. It certainly is a sharp slowdown in China’s pace of growth. But it would still imply that China is the fastest growing (maybe the only growing?) major economy. My tone differed from Nouriel’s tone, but we are both now convinced that China’s economy is slowing quite rapidly.

I tried to be diplomatic, but my riff on net exports directed far more at the Economist than at Dr. Roubini. The Economist has long argued that a) the RMB wasn’t undervalued and b) net exports were not driving China’s growth. It certainly has been true that domestic demand mechanically accounted for more of China’s growth than net exports. But it also has been the case that the acceleration of China’s growth over the last five years has been driven by an increase in the contribution of domestic investment and net exports to China’s growth. China’s current account surplus rose from around 3% of China’s GDP to around 11% of China’s GDP in 2007.

As Nouriel notes, exports are now about 40% of China’s GDP. As importantly, the Chinese value-added in Chinese exports has increased; I have estimated that the value added in China’s export sector is now close to 20% of China’s GDP. Gross US exports are less than 15% of US GDP -- and since some US exports (think Boeing planes) have substantial imported content, US value-added would certainly be less than that. As a result, China is quite exposed -- for a large and diverse economy -- to swings in the global economic cycle.

Moreover, China’s own property cycle seems to be swing from boom to bust at the wrong time. So it is possible that China’s real exports, investment in the export sector and investment in urban property (construction is a big source of jobs) could all slow in a synchronized way. That is what worries most China watchers right now -- the possibility that exports and the main driver of China’s domestic demand growth will fall together, leading to a much larger and sharper swing in China’s growth than most anticipated a few months ago.