China: Accepting the landing

While we might hesitate to liken China’s great credit boom of 2009-2014 as being akin to jumping out of a plane – although there certainly was an element of there being a leap into the unknown – it is clear that China’s economy is landing at present. As to whether the landing will be soft or hard, we are minded to side with George Soros’s comments at Davos, “namely I do not so much expect a hard landing in China, I am observing it”. We estimate that China’s industrial complex is in a recession and that, despite 5% or more service sector growth, aggregate GDP growth is currently around 3.5%. Potentially, this rate may go lower in 2016 and this will definitely count as a hard landing for the PRC.

The question for the rest of the world’s policymakers is, of course, what to do about this turn of events – should they merely accept the landing or try to find some form of cushion. Although the press seems certain that something must be done, we are less certain that this is the case. Perhaps the Bank of England should not delay its rate hikes simply because China is slowing, perhaps the FOMC should stay on its tightening course, and perhaps the Reserve Banks of Australia and New Zealand should not ease.

By way of an example, we can recall that just before commodity prices cracked, the Chilean economy was clearly overheating and suffering from a large current account deficit, consequences we believe of the inflationary effects of the large capital inflows that had occurred between 2005 and 2012. However, following the ‘Tapering Tantrum’ of mid-2013, and the first signs of an approaching possible crack in commodity prices, the Chilean authorities took the opportunity offered by the decline in capital inflows to raise interest rates, reduce domestic credit growth and depress domestic demand. In fact, we believe that the authorities correctly identified that the world was changing as China began its first ‘wobbles’ and that as a consequence their export receipts (and therefore national wealth) were about to come under pressure. Therefore they acted so as to oblige their population to alter their own spending behaviours accordingly. Hence, Chile was among the first of the Emerging Markets to suffer a (near) recession but the positive result of this aggressive policy stance was a sharp reduction in the current account deficit that we would argue left the economy better able to ‘cope’ with the commodity price storm that was to follow.

Indeed, the fact that Chile has managed to contain its current account deficit even after a near 20% fall in its export revenues (in USD terms) is an impressive performance. Had the country not done this, but instead attempted to support its level of domestic demand and incomes via countercyclical policy measures (as the financial markets might have wanted...), then not only might its economy have become still more distorted but its current account deficit might well have trebled and the CLP become another crisis currency. Instead, by holding domestic demand flat as exports declined, Chile’s economy has remained relatively stable and the real GDP data has actually been quite creditable over the last year as a result of the decline in the current account deficit.