There has been much talk about the currency turmoil in Argentina and Turkey, and a number of other emerging market economies, in recent weeks. The real trouble, however, is China.
“Certainly, if there ever is a pause in China’s heady growth, today’s emerging market turmoil will seem like a mere hiccup compared to the earthquake that will ensue”, says Kenneth Rogoff. And surely, there will be a pause in China’s heady growth, right?
We’ll return to that question but consider first the bigger picture. Just a couple of months ago, few would have predicted the emerging market turmoil that we are now witnessing. If the current modest tightening of expansionary monetary policy of the US, in combination with an also modest slowdown of (still) spectacular economic growth in China, can trigger this level of currency turmoil in emerging market economies, imagine what would happen if China’s economic woes were to get significantly worse?
The economic recovery in the US and Europe would certainly be at stake. Joseph Stieglitz is already worried that the West could face a decade of close-to-zero growth and no-jobs-to-get, especially for the young, even without a Chinese crisis. As for other emerging market economies, there is little doubt that a long period of high economic growth and expansion could quickly come to an end, if the Chinese growth engine was to grind to a halt.
How have China’s fortunes become so crucial for the well-being of emerging market economies and the global economy more generally? In the aftermath of the 2008 financial crisis in US and Europe, emerging market economies became the prime source of global economic growth. By some estimates, the contribution of emerging market economies to total global growth in 2010 to 2013 was as high as 70 % – and the bulk of this was driven by China.
This leads to a puzzle. Why, suddenly, are emerging market economies – China included – seen not as the dynamic growth engines of the world economy, but as economies with “deep-seated” structural problems?
First, emerging market economies are already much less of a growth engine than they have been. Three of the BRICS – Brazil, Russia and South Africa now have (inflation-adjusted) growth lower than the US (less than 2.5 %). Second, the economic growth that these economies did enjoy, for a sustained period of time, appears to have been somewhat more reliant on ‘contextual factors’ than previously thought. Based, that is, on high commodity prices, low interest rates and seemingly endless supplies of finance.
Talk of the “rise of the global South” is fading and being replaced by references to the “Fragile Five”; Indonesia, India, Brazil, Turkey and South Africa. These countries suffer twin fiscal and current account deficits, falling economic growth, increasing inflation and last but not least, political uncertainty. Analysts even have a second tier of Fragile Fives lined up; Argentina, Venezuela, Ukraine, Hungary and Thailand (rounding up the usual suspects).
We have looked to emerging market economies for sources of economic growth to help pull the West out of its prolonged stagnation (often optimistically referred to as a “fragile recovery”) – and now we must face up to the fact that these economies are no longer as much dynamic as they are fragile and vulnerable, not so much strong engines of growth as potential sources of contagion.
In the drama of how bad things may get – or not – many point to China as crucial. Will China’s economic slowdown come “in the form of a soft or hand landing”, asks Dani Rodrik (note that economic slowdown is taken as a given).
At the core of China’s current challenges are two fundamental questions. First, can China handle its problem of ballooning local government debt, and the closely related real estate bubble, and hence avert a substantial (even if partial) financial crash? Second, can China (finally) rebalance its troubled growth model?
In regard to China’s problem of local government debt, I recommend a recent report by the IMF. The data presented by the IMF is interesting. And the phrasing is precious. Here’s the concluding remark:
“On balance, the augmented fiscal data suggest that China’s fiscal position is weaker than suggested by headline data but still within sustainability thresholds. At the same time, the higher augmented debt and deficits underscore that China has somewhat less fiscal space than government data suggest and is also more vulnerable to a macroeconomic shock. However, there is still room to use fiscal policy to support demand as needed while following a path of gradual adjustment of its augmented fiscal deficit. Moreover, China has already started the reforms to strengthen fiscal management, especially over local government finances”.
This is a remarkably polite, optimistic and upbeat assessment. Of course, the IMF is compelled to be cautious in phrasing such matters. Consider in contrast the diagnosis of Nouriel Roubini:
“China faces … risk stemming from a credit-fueled investment boom, with excessive borrowing by local governments, state-owned enterprises, and real-estate firms severely weakening the asset portfolios of banks and shadow banks. Most credit bubbles this large have ended up causing a hard economic landing, and China’s economy is unlikely to escape unscathed, particularly as reforms to rebalance growth from high savings and fixed investments to private consumption are likely to be implemented too slowly, given the powerful interests aligned against them”.
Will China be able to handle simultaneously a looming debt crisis and a rebalancing of its growth model? Observers fear that if China is to shift resources from fixed investments to private consumption (which most agree is necessary), it will be difficult to maintain its growth rate at 7.6% (the official target), or higher. If the growth rate slows significantly (to, say, 3-4 %), how will this affect fiscal revenues and real estate markets, so intricately linked in China? How can China boost private consumption while at the same time achieving fiscal consolidation and avoiding a negative spiral of falling real estate prices, company defaults, and decreasing local government revenue?
A particular delicate aspect of China’s predicament is that local governments are deeply dependent on buoyant real estate markets: not only do local governments rely massively on leasing of land use rights as source of fiscal revenue, but they also use land as collateral for most of their (extensive) credit creation. It is difficult to predict, to put it mildly, how this dynamic interdependence will play out if the credit and housing booms in China were to turn.
Jakob Vestergaard, GEG Watch, 16/2-2014
References and suggested readings
Bloomberg News (2014, 14. February ). China Banks’ Bad Loans Reach Highest Since Financial Crisis.
Carrel, Paul (2014, 21. January). Davos dilemma: how to help, not harm, world’s fragile recovery.
Kynge, James (2014, 30. January). Emerging markets: Fear of contagion.
Morgan Stanley (2013, 3. December). Tales from the Emerging World:
Pettis, Michael. (2013, 3. September). Rebalancing and long term growth:
Rodrik, Dani (2014, 10. February). Death by Finance.
Rogoff, Kenneth (2013, 6. February). How Fraguke are Emerging Markets?
Reuters (2013, 26. December). China Slightly Exceeds Growth Estimate at 7.6 %.
Stiglitz, Joseph E. (2014, 6. February) Stagnation by Design
Zhang, Yuanyan Sophia and Steven Barnett (2014). Fiscal Vulnerabilities and Risks from Local Government Finance in China