This week we are hosting an event in Frankfurt that will explore China’s changing role in the global economy. (If you are interested in attending, register here.) Regular readers will know that, in our view, China’s economy is undergoing a structural slowdown that could see annual GDP growth fall to as low as 2% within the next 10-15 years. You can read more about this on our China service. But it raises an obvious question: what might this new era of weaker growth mean for the rest of the world?
One obvious consequence is that, all other things being equal, China’s contribution to global GDP growth will fall. As a rule of thumb, every 1%-pt drop in China’s growth rate directly shaves about 0.2%-pts off global GDP growth. So a slowdown from around 5% on our China Activity Proxy measure now, to 2% within the next decade or so will lower global GDP growth by around 0.6%. But this is just an arithmetic impact and tells us nothing about how China affects growth elsewhere.
Stepping back, it’s true that China’s boom over the past couple of decades has brought benefits to other parts of the world. This is particularly true for economies in Latin America and Africa, as well as Australia, which experienced a surge in demand for their commodities. Producers of capital goods, such as Korea, Taiwan and Germany, also benefited.
But rapid growth in China also imposed costs on other countries. For a start, it created huge industrial displacement. China’s share of global manufacturing has increased from virtually nothing in 1990 to nearly 25% today. The counterpart to this has been a drop in the manufacturing shares of the US and Europe and the associated loss of several million jobs in industry – a huge shock that helped pave the way for Trumpian protectionism.
Chart 1: China Current Account Balance (% of GDP)
More generally, as Chart 1 shows, it’s also the case that China’s boom came alongside a sharp rise in its current account surplus. This represented a drag on demand in the rest of the world. And because that required the Fed and other major central banks to respond by keeping policy extremely loose, it helped to sow the seeds of the global financial crisis.
If China’s rise created winners and losers, it is therefore likely that a new period of weaker growth will do the same – hitting some economies relatively hard, but largely bypassing others. When thinking about how this may play out, we need to consider three things.
The first is the nature of China’s slowdown – does it take the form of a smooth adjustment to a new, lower, rate of growth or is it a more abrupt downturn perhaps precipitated by a financial crisis?
The second is the demand implications of slower growth in China. Is it driven by weaker consumption or weaker investment? And, related to this, what happens to savings and therefore the current account position?
The final aspect to consider is the global supply-side implications of weakness in China. If innovation and productivity growth in China slows, what are the spillovers to innovation and productivity in the rest of the world?
We explored all of these issues in a recent publication, which you can find on our website. Suffice to say that, while the slowdown in China that we’re forecasting looks dramatic, the implications for rest of the world at an aggregate level may be quite limited.
Our base case is that China will avoid what others have labelled a “hard landing” – instead we think growth will slow gradually towards 2% or so over the next decade. This should limit the extent of any financial dislocation.
On the demand side, we suspect that weaker growth will be led by a slowdown in investment, which in turn will weigh on demand for some (but not all) commodities. Our commodities team have identified four commodities that are most vulnerable to weaker growth in China – iron ore, coal, copper and soy beans. Economies that are most dependent on the production of these commodities therefore stand to lose most as China slows. This includes Brazil, Chile, Peru, Argentina and Australia. But producers of other commodities, including oil, may be less affected.
More fundamentally, a combination of weakening investment alongside a persistently high savings rate means that, in our view, China’s growth slowdown is likely to be accompanied by a rebound in the current account surplus. As I noted earlier, this would represent a drain on demand in the rest of the world and – in the extreme – could threaten a re-run of some of the problems caused by China’s saving glut in the 2000s.
Chart 2: China Current Account Balance (% of World GDP)
In practice, however, China’s surplus is unlikely to return to the highs it reached last decade. Chart 2 shows our forecast for China’s surplus expressed as a share of global GDP. A rebound on this scale would be a headwind for the rest of the world, but one that could be offset by looser policy in other countries if necessary.
What about the supply-side damage caused by weaker growth in China? The key point here is that, unlike other major EMs, China doesn’t just replicate processes and technology used in advanced economies – it also makes a significant contribution to innovation and development at the technological frontier. It follows that if there is less innovation and weaker productivity growth in China in future, then global innovation and productivity will suffer.
However, it would be easy to overplay these effects. After all, China’s rapid development over the past couple of decades has come alongside a sustained fall in productivity growth in the G7. This doesn’t mean that China’s contribution to global science and innovation had no impact – it’s just that the impact was overwhelmed by other factors.
As I’ve discussed before, one of the big puzzles in macroeconomics over the past decade has been why the rapid development of digital technologies has failed to deliver improvements in productivity growth in the US and Europe.
Part of the answer may be that this is a hangover from the global financial crisis, which should eventually fade. There may be measurement problems too – the fact that many digital services are essentially free makes it difficult for the statisticians to capture their effect on GDP. And it may simply be that it takes time for infrastructure and processes to adapt to technological developments in order to realise the full benefits to productivity.
However, whatever the explanation – and we happen to find the last one compelling – the key point is that the future growth prospects for most of the world’s advanced economies will be determined mainly by whether the productivity boost from digital development remains elusive, rather than by developments in China.