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24 May 2013

Many investors 'not in real world'

Stephen King

by Stephen King

HSBC Group Chief Economist

Investors not living in real world

A Chinese slowdown, alongside anaemic recoveries in the developed world, is a headache for policy makers

No one can be strong when China is weak. That, at least, appeared to be the message from the economic data this week. New data suggest lacklustre growth in China – sparking nervous sell-offs in other countries. A one-day decline of over 7 per cent in the Nikkei stock market index might seem like an overreaction but, last year, China was Japan’s most important export destination, accounting for more than 18 per cent of its goods exports. China now accounts for one-quarter of South Korea's exports. China is also the third-largest destination for US exports, after Mexico and Canada.

Stock market wobbles cannot be attributed to China alone. Ben Bernanke, Federal Reserve chairman, revealed that asset purchases associated with quantitative easing (QE) might be tapered earlier than investors expected, providing another reason for stock markets to lurch down. Meanwhile, rising bond yields in Japan have led to a new sense of unease: financial bets are no longer all one way.

The Chinese economy is not about to collapse. Continued urbanisation should deliver productivity gains fast enough to allow it to continue outperforming other countries

The relationship between China and the rest of the world has changed significantly in recent years. Before the onset of the global financial crisis, China’s growth was heavily export-led and primarily driven by productivity-driven gains in competitiveness. Adjusted for inflation, exports rose between 20 and 30 per cent a year. Since the crisis, export momentum has faded rapidly. In 2012, exports rose a mere 6 per cent, held back in part by trauma in the eurozone. One consequence has been a remarkable reduction in China’s current account surplus, dropping from over 10 per cent of its gross domestic product in 2007 to 2.6 per cent last year.

During this period, China has tried to limit the pace of its economic slowdown by boosting investment in infrastructure. There is a strong case for doing so. The average rail density per square kilometre in China’s 10 largest urban cities, for example, is just a quarter of the developed world’s typical urban areas, according to the Organisation for Economic Co-operation and Development.

Yet the boost to infrastructure investment has not been without its costs. Credit growth has been excessive, capital has been allocated inefficiently and productivity increases have faded. While the reduction in China’s surplus can be regarded as a welcome contribution to the easing of global financial imbalances, it has coincided with a loss of domestic economic momentum that is weighing on growth well beyond China’s borders.

The Chinese economy is not about to collapse. Continued urbanisation should deliver productivity gains fast enough to allow it to continue outperforming other countries.

Unlike most developed nations, there is still some room for manoeuvre on fiscal policy. But a Chinese slowdown, alongside – at best – anaemic recoveries in the developed world is a headache for policy makers. The temptation to pursue policies of economic nationalism is on the increase.

QE and other related policies operate primarily through two channels. The first is the so-called portfolio channel, whereby central bank purchases of government paper lead to lower long-term interest rates, encouraging investors to switch into higher-yielding but riskier assets. This is supposed to make it easier for companies to raise money, boosting investment; households should also enjoy bigger gains in wealth, thereby prompting faster consumer spending.

This channel has not worked as well as expected. Asset prices have surged but the results have been mediocre. A gap has opened between financial hope and economic reality. By limiting export prospects for producers elsewhere in the world, a slowdown in China only widens the disconnect. Removing monetary support threatens to close the gap in abrupt fashion - not because of a pick-up in activity but via a sudden correction in asset prices.

The second channel works through a falling exchange rate. Some argue that one country’s QE-related exchange rate decline will ultimately bring benefits for other countries. Faced with a loss of export earnings, those who have chosen to avoid QE will eventually be forced to follow suit, thereby triggering more in the way of domestic portfolio effects.

But if the domestic economic effects of QE are disappointing, the primary effect of exchange rate declines will be to boost exports. With lacklustre global growth, that will surely lead only to accusations of currency wars. This second channel is bound to be a source of tension in Asia in the months ahead thanks to Japan’s massive continuing monetary loosening.

At the beginning of the year, there were high hopes that the world economy would be dragged out of its torpor thanks to the copious use of monetary drugs, recovery in the US and strength in China. Monetary drugs, however, appear to have hallucinatory effects.

In the absence of a recovery in the developed world, China’s slowdown is just one more reason to question whether financial investors have remained in touch with economic reality.

This article originally appeared in the Financial Times on 23 May 2013.
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