China’s annual economic growth has slipped to around 7 per cent and is facing an increasingly uncertain outlook. We envisage three broad potential scenarios for China: the good, the bad and the ugly.
This is our base-case and the consensus view on China. In this world, Chinese authorities continue to gradually loosen policy. Result - the economy responds to the stimulus, the property market stabilises and major economies outside of China continue their gradual recoveries.
Chinese growth rebounds in the second-half of the year to achieve the government’s target of around seven per cent real GDP growth for 2015. In other words, authorities are successful in striking a balance between growth and structural adjustment.
Under this scenario, the weakness in the Chinese property market continues to undermine the economy. Authorities fail to deliver sufficient stimulus to support domestic activity for fear of making the current economic imbalances even worse.
That is, policy makers waver at substantially boosting fiscal spending on the back of concerns over local government debt levels.
Faced with an ongoing slide in the property market, real GDP growth could drop below six per cent in 2016. All-in-all, this would represent a hard-landing by China’s standards.
Growth in Chinese domestic demand would be even harder hit, falling to five per cent, which would be the worst performance since 1990.
In response to the bad scenario unfolding, Chinese authorities shift their focus from stimulating domestic demand to supporting the external sector. They could, in effect, join the global currency wars by devaluing the yuan. While this may support Chinese growth and employment, it would largely be at the expense of growth elsewhere in the world.
Our simulations with QIC’s proprietary version of the NiGEM global economic model suggest that a 10 per cent devaluation in the Chinese yuan over a two-year period, sparked by weaker Chinese domestic demand, could wipe-off around 30 basis points from real GDP in the OECD region after two years.
Economies with close linkages to the Chinese economy would suffer the most from the loss of competitiveness, particularly those in Asia, while the Japanese economy would shrink by ½ ppt. South Korean real GDP would be expected to fall by around one per cent after two years.
This ugly scenario would lead countries to respond to their appreciating currencies by easing monetary policy. Central banks in Asia would need to aggressively cut rates, with cuts in excess of 50bps likely in South Korea and Taiwan. Central banks in Europe and Japan would be forced to extend their quantitative easing programs as the inflation outlook weakens.
Central banks considering raising rates over the coming 12 months, such as the US and UK, would end up adopting a much more gradual approach. Our simulations suggest the shock would reduce the extent of tightening from the US Federal Reserve by 50 basis points after two years; with rates rising to around 1.75 per cent by the end of 2017 cf 2.25 per cent as in our baseline.
Australia is different from most other developed economies in that we are net commodity exporters with a large exposure to iron ore and coal, whose prices are largely determined by Chinese demand. Translation - the consequences for the Australian economy are potentially severe.
The situation in Australia is exacerbated by the dwindling space that Australian policy makers have to respond to negative global shocks, such as a slowdown in China.
Let’s begin with the impact on iron ore and terms of trade. We estimate that a slowdown in Chinese demand to five per cent would take iron ore prices back below US$50 and to lower Australia’s terms of trade by 10 per cent.
The currency response of the Australian economy to the fall in the terms of trade also differentiates us from other developed economies and Asian trading partners. Whereas the non-commodity nations experience rises in their currencies of 10 per cent against the renminbi, the drop in Australia’s terms of trade lowers the AUD by five per cent against the USD, but still leaves it five per cent higher against the renminbi.
The dual impact of a drop in Chinese demand and falling terms of trade and deterioration in competitiveness against China producers hits the mining sector. We expect Australian export volumes to fall by $9billion in 2016 and $14 billion in 2017, to be 3.5 per cent lower than base at the end of 2017, as miners cut back on supply and as Chinese steel producers substitute the relatively cheaper local iron ore and coal product for the Australian product.
The drop in profitability of mining leads to a fall in business investment from a consensus -2.0 per cent in 2016 to -6.0 per cent, as mining companies pull back on the few remaining expansion plans. Pressure on profits of the mining sector and of corporates in general place further pressure on Federal and State government budgets.
We estimate that the Federal Budget would be hit by a revenue shortfall that would build to $10 billion a year by 2018.
Our modelling (Figure 1) suggests that the hit to GDP and the sustained rise in the unemployment rate that would follow would place pressure on the RBA to cut rates to 1.25 per cent by the end of the year and to sustain that rate throughout 2016.
However, the impact this would have on the housing market would make such an aggressive move untenable, with a cut to 1.75 per cent more likely. In the scenario without aggressive rate cuts, economic activity remains below trend into 2017, rather than picking up to trend by 2016.
This highlights the fragility to external shocks that the Australian economy currently finds itself in. With the transition from mining to non-mining activity occurring slowly, the inability of policy makers to respond to any deterioration in external conditions would condemn the economy to a lengthy period of sub-trend growth. A hit to growth from an external shock such as this would extend the number of sub-trend growth years since the GFC to eight out of nine years over the period 2009 to 2017.
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