China hard landing could still blow up world - Société Générale


Matthew Turner
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Société Générale reveals the disfigured face of the global economy in the event of a China growth shock, given the country’s unsustainable investment rate – its all-too familiar Achilles heel.

The slowing of China’s growth miracle in the third quarter of 2012, coupled with concerns over leadership transition and creeping investor appetite, saw the world’s most populous nation losing its status as the safest of the Brics.

Recent results from Euromoney’s Country Risk Survey – a well-known survey of analysts’ views of economic and political risk – reflect the increasing risk sentiment growing towards China, with the sovereign slipping behind Brazil for the first time in the ECR rankings to become the second-safest Bric economy.

However, the perennial China blow-up thesis was proved wrong, yet again.

Yet such concerns were recently reassessed in the Global Economic Outlook report published by Société Générale on Tuesday, which points to the worst-case scenario of a Chinese hard landing and suggests it is by no means inconceivable.

Unsurprisingly, SocGén bases its assumption on China’s over-dependency on gross fixed capital formation. The report states:

“The Chinese economy is still imbalanced. Almost half of GDP comes from gross fixed capital formation, up from slightly more than a third in 1997.”

Real GDP growth scenarios

With China forecast to grow 7.4% in 2012, according to the report, SocGén calculates 6% GDP growth as the hard-landing threshold:

“We define a hard landing in 2013 as one where the official, full-year, real GDP growth rate plummets to below 6%, which we see as the minimum level needed to keep the job market stable and avoid systemic financial risk.

“As China undergoes demographic ageing and growth of the working-age population slows, this minimum stable growth level will decline further. However, if progress in rebalancing and structural reform remains slow, the probability of a hard landing will rise over the medium term."

Alarmingly, if investment remains unchanged, 3% real GDP growth is estimated as the worst-case growth scenario. The report states:
“If investment simply stays unchanged, growth will mechanically drop to 4%. The collapse in confidence would further cut growth to 3%. Less than 5% of our survey respondents expect growth to be below 3.5% in the worst reasonable case.”

A credit-fuelled boom?

The report suggests a hard landing could be triggered by two downside event risks: a Lehman-style credit crunch and a property market correction:

“Two types of events could trigger a hard landing in China. First, the experience of 2008 showed that the Chinese economy is vulnerable to trade shocks. The Lehman crisis made exports go into reverse, resulting in the loss of nearly 50 million migrant worker jobs in the two quarters after it took place.

“Second, a hard landing could be provoked by either insufficient public investment from Beijing or a sharp property market correction, which could also be partly induced by tight policies.

“In this tail-risk scenario, 2013 will see several quarters with just 3% growth, and full-year growth would stand at just 4.2% compared with our central scenario of 7.4%.”

Impact on global economy

So, how would a Chinese hard landing impact the global economy? SocGén hypothesizes two likely impacts: mechanically – since China is core to the global economy – and through trade, financial and market channels. The report states:

“Mechanically, a slump in Chinese GDP growth to just 3% would cut our global GDP growth forecast by 0.6 percentage points. Add to that the channels of transmission to the global economy, and our expectation is that a Chinese hard landing would result in 1.5pp being slashed from global GDP growth in the first year.”

Drawing on different studies, mainly from the IMF and the OECD, SocGén estimates that the impact of the trade channel from the type of hard landing in China described in the study would be a:
“...cut in GDP growth by around 4.5pp in Taiwan, 2.5pp in South Korea and Malaysia, 1.2pp in Australia, 0.6pp in Japan, 0.3pp in the euro area and 0.2pp in the US.

“For the global economy ex-China, the trade channel effects would bring about a reduction of around 0.7pp to GDP growth.”

These shocks to global growth would savage financial and trade flows, triggering a flight to the dollar. The report states:
“A China hard-landing scenario assumes a 10% dollar appreciation in the first year and this despite additional QE from the Fed.

“It does not take any great stretch of the imagination to paint an even bleaker scenario in which a China hard landing triggers outright currency wars and protectionist measures on trade flows. This would further aggravate the negative impact of a China hard landing and extend the duration of the shock.”

The jury is out on whether the China blow-up thesis deserves to be in fashion this season, but SocGén has highlighted the global turmoil that would ensue.

In any case, the near-term China risk for the region is dramatically underscored by its acrimonious territorial dispute with Japan, as ECR recently noted from an interpretation of Q3 survey results.