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How important is China, really?

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Stability in the yuan's exchange rate is one key to how the world might handle China's slower economic growth.   © Reuters

The Chinese mainland is in a tough spot. And the world is feeling the pain. In the first two weeks of 2016, tumbling Chinese equities and a volatile currency knocked the wind out of global financial markets. The worry is that China's economic slowdown and a weaker yuan could harm growth the world over. The mainland economy, after all, is now the world's second largest after three decades of stellar growth.

     China has nearly single-handedly driven the global commodities boom over the past decade, lifting incomes from Latin America, the Middle East, Southeast Asia, to Canada, Australia and New Zealand. With its economy now slowing, raw material prices are coming back down to earth, a plunge exacerbated by the downturn in once rampant mining investment.

     Advanced economies, such as South Korea, Japan, Germany and the U.S. benefited, too. Car sales in China, led by foreign brands, have soared, exceeding even those in the U.S. last year, itself a record. Rapid construction and investment have also sucked in imports of machinery, a welcome relief at a time when demand elsewhere fizzled in the wake of the global financial crisis.

     Meanwhile, Chinese tourists have taken to the road, flocking to hotels and snapping up luxury goods from New York to Milan and Tokyo. Even real estate prices in the world's major cities have been bid up in part by Chinese investors keen on a pied-a-terre in a faraway place. Meanwhile, Chinese companies, once intensely focused on the home market, have started to expand abroad, providing capital where it was sorely lacking.

     No wonder, then, that investors across the world are looking at China with trepidation. Slowing mainland demand growth would undoubtedly hurt, and a hard landing even more so. But the direct linkages between China and the world economy can also be overstated. Yes, China, with its dazzling growth trajectory, gave a struggling world hope for a brighter future. But the numbers did not always translate into the big profits sought by Western companies lured by the country's nearly 1.4 billion consumers. That is not to downplay the importance of China for the world economy, but at the same time a little perspective is required as well.

The bigger picture

Take the example of Japan, an economy that roared in the 1980s, undermining the West's manufacturing dominance, and which underwent a spectacular real estate boom at the same time. Many dreams were dashed in 1989 when property prices started to tumble and the Japanese economy slid into a prolonged slump. The world, however, sailed on, largely oblivious to the country's economic malaise.

     At the time, the Japanese economy accounted for 15.5% of world gross domestic product in U.S. dollar terms, exactly China's share in 2015 according to International Monetary Fund data. On the face of it, China is a much bigger buyer of goods on world markets today than Japan was at the peak of its 1980s expansion, taking in 10.3% of world imports last year against Japan's 6.5% share in 1989. But these numbers are misleading.

     A large chunk of Chinese overseas purchases today are still used for exports, and are thus insensitive to local demand. Although precise estimates are difficult to come by, a rough rule suggests that about a third of Chinese imports are used for export processing. That would leave the share of world imports ultimately dependent on Chinese growth at 7.2%, only a sliver higher than Japan's in 1989.

     There are other important parallels with the Japanese experience. The country's boom in the 1980s, just like China's currently, was entirely self-financed. Excess savings prevailed in both episodes, limiting the direct financial linkages with the rest of the world. On the whole, the Japanese, like the Chinese today, owed their debt to themselves. This is in stark contrast, for example, to the U.S. in the run-up to the global financial crisis in 2008, where the boom was to a considerable extent foreign-financed. No wonder financial stress quickly spread far and wide.

Key concerns

Yet, China still matters. In fact, in various respects, a slowdown in mainland growth should have bigger global repercussions than did Japan's deceleration in the late 1980s.

     First, the global economy is much wobblier today. Economic growth is already lackluster, with a smaller shock presumably sufficient to knock the world off track. In 1989, by contrast, the Berlin Wall came down, allowing former Communist economies to eventually join the world economy, unleashing enormous growth potential.

     Second, the policy room to cushion against weakening demand in the east is a lot more limited today. Interest rates are already near zero in most major economies and fiscal balance sheets have been levered up. Political gridlock, too, appears to hamper progress on structural reforms in many countries. It was not always quite so. Think only of European unification, with the creation of the single market in the late 1980s and early 1990s, and subsequent preparations for the European monetary union, helping to lift growth in many peripheral economies across the continent.

     Today, few such ambitious endeavors are underway. One exception might be attempts at further trade liberalization, such as the Trans-Pacific Partnership, the Regional Comprehensive Economic Partnership, a free trade agreement for Asia, or the Trans-Atlantic Trade and Investment Partnership. But none of these have yet been implemented and their ratification remains uncertain. Still, these could ultimately help world growth, just as the ratification of the Uruguay Agreement in 1994, and subsequent establishment of the World Trade Organization, spurred trade for much of that decade and into the new millennium.

     In short: China's share of the global economy may be comparable to that of Japan in the late 1980s, but the world's defenses are down, leaving other economies more exposed to a growth wobble. Yet how much pain will ultimately be shared by the global economy crucially depends on exchange rates. Worries over the value of the yuan -- with a slight fall in its value against the dollar in recent weeks prompting sharp volatility across markets internationally -- highlight this. A substantial depreciation of the yuan would make Chinese producers more formidable competitors globally and deprive other economies selling goods to the mainland of revenues.

Currency is key

And here probably lies the real key to why Japan's stumble in the late 1980s did not disrupt global growth: In subsequent years the yen appreciated, rather than lost value, sparing trading partners an even bigger hit on top of already slowing Japanese demand. Today, the value of the yuan will prove equally important: A sharp depreciation would push the country's deflationary pressures overseas, while exchange rate stability would cushion the rest of the world against slowing mainland demand.

     Fortunately, there are good reasons to believe that China will not let the yuan fall. First, China does not have a problem of external competitiveness. In 2015, it still gained global export market share. A sharp depreciation would only prove disruptive to global financial markets and thus reduce overseas demand for the country's goods -- a self-defeating exercise. Second, China's main problem is domestic: a rapidly deflating housing construction bubble. To prevent this process from affecting other parts of the economy, greater stimulus is required. However, if the currency depreciates and capital flows out of the economy, policy measures to lift local demand will face ever stronger headwinds.

     This, of course, may not mean that the yuan will appreciate as the yen did between 1990 and 1994, but as long as it remains broadly stable, the rest of the world will be spared the full brunt of China's domestic demand downturn. Assuming a stable currency, therefore, the world should be able to live with a gradually slowing China. Anything more dramatic, such as an outright contraction in GDP, would be much harder to swallow. China, clearly, is important -- but not that important.

Frederic Neumann is co-head of Asia economics research at HSBC.

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