Much has been said about China in the past year. Now, courtesy of Morgan Stanley’s Chetan Ahya, here is one additional data point revealing why China will be ground zero for the next global economic slowdown.
As Ahya notes in his Sunday Start note, “several large economies in the world including but not limited to the US, euro area, China, Japan and UK are facing the 3D challenge of demographics, debt and disinflation. Among these economies, we believe that China, which currently accounts for 18% of global GDP and 27% of global manufacturing and contributes 45% to global growth, will be the biggest drag towards lower nominal GDP growth and consequently lower expected returns.“
Surprisingly, unlike many other Chinese doomsayers, Morgan Stanley does not think the catalyst of China’s upcoming “hard landing” will be financial, or debt-related:
The key concern that investors have on China is that its debt build-up could result in a potential financial shock, which would be akin to the experience of the US in 2008 and emerging markets in the 1990s. However, we think that the macro set-up and policy preferences will mean that the risk of a financial shock in China is low. There are three key characteristics of China’s current macro set-up: i) Debt is being largely funded domestically, i.e., China is misallocating its own excess saving; ii) It remains a net creditor to the world (with a net international investment position of 14.7% of GDP) and it runs a current account surplus; and iii) It is facing significant disinflationary pressures, which will allow the central bank to inject liquidity to manage any potential risk-aversion in the domestic financial system. While there are non-performing loans in the banking system, policy-makers will likely have significant control of liquidity conditions to prevent a financial shock, in our view.
Ideally, a quick adjustment approach following our five-step process of accepting lower potential growth, cutting excess capacity/recognising non-performing loans, recapitalising banks, cutting real interest rates and stimulating consumption with fiscal transfers to households for education and healthcare is needed to transition to a new productive growth cycle.
That however, is unlikely for a country in which social tensions and rising unemployment are already the thing that keeps Beijing up at night: “However, considering the risks to social stability, a quick adjustment appears unlikely to us. Given its macro set-up and policy preference, we have long argued that the developments in China are more comparable to that of Japan in the 1990s.”
So in lieu of a quick adjustment, a “gradual adjustment approach” would leave us with the outcome of an extended period of excess capacity, disinflationary pressures and declining nominal growth and returns in the economy. At the current pace of new investment that China is taking up, the incremental return on capital employed will likely continue to deteriorate.
Morgan Stanley calculates that “although China has slowed its investment since 2012, we expect it to invest 41% of its GDP (US$4.7 trillion) in 2016. This compares with the 24% of GDP which China should have been investing if it were to maintain the same capital efficiency as it did between 2000 and 2007. China currently needs new investment of 6.4pp of GDP to achieve 1pp of GDP growth, compared with the average of 3.6pp between 2000-07.”
It is this unsustainable trend of relentless capex spending and investment that MS believes is the reason “why China will weigh on the trend in global growth and returns.”
In a globalised, integrated economy, the impact will extend well beyond China’s weight in the aggregates as it will also influence returns in other parts of the world via its role as a large market but, more importantly, as the marginal competitor.
And here is the chart revealing what may be the most unsustainable trend in China, one that is even more dramatic than China relentless debt growth: accounted for 26% of global annual capex in 2015, compared with 9% in 2006 and 5% in 2000. Hence, as China continues to invest with low return expectations, that this will continue to weigh on the global returns on capital employed.
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So can the global economy grow out of China’s adverse impact like it did in the 1990s in the face of Japan’s structural slowdown then?
According to Morgan Stanley, such an outcome seems unlikely. Back then, none of the large economies ex-Japan suffered from the 3D challenge. Indeed, until recently, the emergence of China (with sustained high productivity growth) and its integration into the global economy was itself a key factor which had helped to sustain the global growth dynamic post the structural slowdown in Japan. However, the state of the global economy excluding China today is much weaker and, with no large emerging market ready to replace China as an engine of global growth in the near future, we could well be stuck in a lower nominal returns world.
Who will suffer the most when China’s plane if not crashes, then downshifts permanently?
The impact from China will be most keenly felt in the industrial segment and, indeed, economies in Europe, Japan and Korea, which have both a higher share of industrial activity in their economic output and also closer trade links with China, will be most exposed, in our view. The disinflationary pressures, coupled with the depreciating RMB, will also weigh on the inflation trend in the DMs, particularly in the US, and this is one of the key external factors keeping the Fed on hold and Treasury yields low.
Needless to say, should the Fed proceed to hike and spike the dollar some more, all these adverse dynamics will accelerate that much more.
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