Chinese crisis, do you need to worry?

What could have been a quiet summer started with the busy weeks of the Greek referendum and new program, to continue in the busy weeks of financial volatility around the Chinese crisis.

China: correction or hard-landing? Looking at spillovers

The Chinese crisis: structural imbalances and leverage behind the correction. Assessments vary on the nature of the current crisis.

For some, China is simply experiencing a correction in its overinflated equity market. Nicholas Lardy (Peterson Institute), among others, argues (see also his op-ed) that China’s economy is still holding up reasonably well—(i) still growing at 7 percent this year; (ii) the economic decline in the industrial sector reflects the move towards the services sector; (iii) the renminbi is holding strong against the US dollar.

For other, the crisis reflects deeply rooted issues. Gene Frieda (Project Syndicate) describes China’s increasingly two-tracked economy—a new track based on services and consumption burdened by an old, slower track made up of industries, with the real-estate market in the middle, characterized by massive overcapacity in mid-size and smaller cities and robust demand in large cities. All compounded by the Chinese leadership’s insistence on sticking with high growth targets but the growth miracle being eroded by a debt overhang. Andrew Sheng and Xiao Geng (Project Syndicate) highlights three structural imbalances: (i) the banking system, with a maturity mismatch, (ii) balance sheets with too much debt relative to equity, and (iii) an imbalance between the state and the market. They argue that it is time to focus on private-sector players, radically upgrading capital markets and actively promoting private innovation and investment. These arguments are questioned by Anton Cheremukhin et al. (VoxEU) who take a longer term perspective on the current situation.

Policies: the worrisome ineffectiveness of the Chinese government. Michael Boskin (Project Syndicate) notes that China needs to shift away from excessive state control, reducing administrative discretion and introducing sensible, predictable regulation to address natural monopolies and externalities. RBS analysts review this shift to a more balanced growth model, rather than one based on investment and debt, but find that the results are mixed and reform efforts still unclear (The Revolver).Stephen Roach (Project Syndicate) also cautions against the authorities’ temptation to do too much in the efforts to push beyond the per capita income threshold that China has attained—what is needed is to simplify and clarify an agenda that risks becoming too complex to manage. For Boskin, at the macro level, China needs to reallocate responsibilities and resources among the various levels of government, and gradually reduce its total debt load. He stresses that China must avoid reverting to greater state control.

Deleveraging is central to a sustainable exit from the crisis, as stressed by Alicia Garcia-Herrero (Bruegel). Including households, China’s total debt is close to 300% of GDP, with over-borrowing traced back to crisis policies. Exposure to dollar debt has ballooned. The need to clean up the banks and the negative impact of excessively high debt on growth means that China can no longer stimulate its economy. Gene Frieda (Project Syndicate) agrees and sees a growth crisis within the next 12-24 months.

Spillovers: complacency or reality? Guntram Wolff and Thomas Walsh (Bruegel) review two competing hypotheses on potential contagion to Europe—one argues that the needed market correction is not a warning of deeper weakness in the Chinese economy; the other links it to a slowdown in economic activity in China, which would be passed on through trade linkages to China’s trading partners. They warn European policy makers that a more fundamental cooling of China could have important consequences. Martin Wolf (FT ) writes that the market crash itself is not the important event but it reflects the sheer scale of the task confronted by the Chinese authorities—and their worries about it. He also writes that a shift of strategy back towards export-led growth would have disastrous consequences for the global economy. Marco Valli and Edoardo Campanella (Unicredit, hat-tip EuroIntelligence) undertook a China stress test for the eurozone. If Chinese growth decelerates from 7% to 3% over the next five years, the accumulated impact on the eurozone would be a reduction in the level of GPD by 1-2%.

RBS Silver Bullet, providing a market view, writes that China’s controlled credit crunch could increasingly become a hard landing. William Buiter (Citigroup) reinforces this point as he sees China leading the global economy into a recession. The volatility has hit equity and currency markets, but debt overhangs are equally dangerous to vulnerable countries, particularly Brazil in EM and Australia in DM. Regional neighbors and commodity exporters are most exposed to a China slowdown, through direct trade linkages, as estimated by Paolo Mauro (Peterson Institute). One impact of the recent turmoil in emerging markets is the weakening of EM currencies. For Andres Velasco (Project Syndicate), EM central banks can intervene, if they have reserves and the will to abandon (at least temporarily) commitments to floating exchange rates. The current overshooting also reflects a sharp growth slowdown and a sudden deleveraging imposed by foreign creditors. For Dani Rodrik (Project Syndicate), the recent turmoil shows that there is no coherent growth story for emerging markets—with often high growth rates driven not by productive transformation but by domestic demand, in turn fueled by temporary commodity booms and unsustainable levels of public or, more often, private borrowing.

Greece: the program beyond the elections

Elections and program implementation. The backdrop for the forthcoming elections is the sharp deterioration in market conditions for manufacturers in Greece (Markit PMI, see EuroIntelligence). EuroIntelligence reports the political decline of Alexis Tsipras, with polls showing his shrinking position (see Reuters). For EuroIntelligence, the election is a sideshow as, whatever the outcome, Greece is unlikely to achieve the targets of the bailout program. EuroIntelligence also reports on the recent political developments, including the indecisive debate between Tsipras and Meimarakis (summaries available by Kathimerini, ToVima, Macropolis and Reuters).

Jacob Funk Kirkegaard (Peterson Institute) foresees that these elections are most likely to provide political continuity, return Tsipras to power, and help put the country on a path toward a stable economic recovery. The timing gives little time to the opposition to organize itself. The ESM program is structured in a manner so that no immediate financial risks for Greece will emerge from a slight delay for the first program review. New Democracy (ND), which is Syriza’s only real rival to become the biggest party and receive the additional 50 bonus allotment of members that goes to the party that finishes with the most votes. ND is still led by Evangelos Meimarakis, a stopgap interim leader without charisma and lacking any independent political platform. For Kirkegaard, a Tsipras victory, and the transformation of Syriza into a mainstream center-left party, would be the best guarantor for implementing the new program.

Debt relief: a silver bullet? Christian Odendahl (hat-tip EuroIntelligence) makes the case for an outright debt haircut—based on the annual gross financing need. Greece annual gross financing needs are 25% now, and scheduled to be around 20% once the various official payments begin (the IMF uses a ballpark indicator of 15% of GDP as one that is deemed sustainable by financial markets). Even if Greece reaches its targets for GDP growth and primary surpluses, the debt burden will need to be reduced. A haircut is the cleanest solution. Odendahl recommends three courses of action (i) taking Grexit off-the table for good; (ii) tying debt-relief to GDP growth; (iii) making new private claims senior to existing official and private claims.

The importance of structural reforms. Christoph Schmidt (Project Syndicate) argues that debt relief is not the silver bullet for Greece’s crisis, as the country faces even stronger drags on growth, including structural weaknesses and political brinkmanship, that must be addressed first. A restructuring of Greece’s official debt, despite offering short-term benefits, would weaken that framework in the long run by setting a precedent for exceptions, with other eurozone countries, sooner or later, requesting the same concession. At the European level, the German Council of Economic Experts’ proposed set of reforms (the principles of “Maastricht 2.0”) emphasize national responsibility for public finances and international competitiveness. Edmund Phelps (Project Syndicate) also looks at Greek growth, and writes that much of the decline in employment in Greece occurred prior to the sharp cuts in spending—weighing against the hypothesis that “austerity” has brought Greece to its present plight. He calls for the right structural reforms, with ownership from Greece.

Looking back: the first programs. Medium looks back at the initial Greek program (see also Parts One and Two) and concludes that the 2010 Greek bailout program was the very natural outcome of a highly risk-averse set of Eurozone politicians and civil servants, under extraordinary constraints. The ECB contributed by interpreting its mandate incredibly narrowly and asking fiscal funding to perform an essentially monetary role. The damage done to the Greek economy was done by the conditionality, not the debt. For Arvind Subramanian (Project Syndicate), the IMF is at fault in the Greek crisis for not providing an alternative to two stark choices: leave the eurozone without financing, or remain and receive support at the price of further austerity. The third option would have been to leave the euro, but with generous financing. He argues that assisted Grexit remains available, for which the IMF should plan.