Ignacio de la Torre. Professor. IE Business School
30 September 2015
The seismic changes taking place in China will have devastating knock on effects in many emerging economies, while western countries will remain largely unaffected.
The Shanghai stock exchange was founded in the middle of the nineteenth century, and was closed after the Second World War by the communist party, only to be reopened in the mid 1990s in line with reforms by Deng Xiao Ping. Today, many Chinese communists who bought shares in June following the recommendation of the “People’s Daily” newspaper will be asking themselves if it would not have been better to leave it closed.
My last article before the holidays was headed “China: the end of the story”. In it I said that not only was China’s GDP set to grow more slowly than the rate quoted in official forecasts (7%), but also how China was at serious risk of facing a “forced landing” due to the enormous financial and real estate imbalances accumulated in recent years. During the summer this explosive cocktail blew up, and we saw a severe slowdown in economic activity, an acceleration in capital flight, a surprise devaluation of the yuan, and the collapse of the Chinese stock market with a loss of 5 trillion dollars in value.
With all this going on, the focus of analysis in my opinion, has to center on the magnitude of the damage this has done in China, in order to calibrate the impact it will have on other countries in the form of contagion. This will occur in several ways. The first thing to happen will be that a marked drop in Chinese imports will hurt countries that export goods and services to China. If these sales comprise a large percentage of GDP, the level of damage could be alarming. Second, lower Chinese demand will do particular harm to the prices of raw materials, which means that economies that depend on these will have some very hard years ahead. Third, the devaluation of the yuan has made Chinese exports far more competitive, which could mean that the same goods from other countries are now comparatively less competitive. Fourth, a crisis makes people more risk-aversive, which in turn has led to brusque movements of capital that harm countries with a current account deficit, which will have to respond by raising interest rates, reducing reserves, or reducing their aggregate demand (which would make their GDP plummet).
Based on the above analysis it is easy to draw the following conclusions. First the contagion effect will harm western countries very little, and yet it will be devastating for emerging countries. The percentage in which western countries are exposed to China via exports is miniscule (3%), and they will benefit in general terms from a fall in the price of raw materials and capital flights, given that risky countries see capital leave and funds flow toward more “secure countries,” a trend which explains the strength of the euro. Meanwhile emerging countries are in the line of fire. On the one hand many countries are far more exposed to changes in China (particularly countries in Africa and South East Asia). Also, many emerging countries have not used the raw material bonanza years to diversify their economies, which means that now they have to face a massive downturn in the price cycle and are condemned to a deep economic crisis (like Russia, South Africa, and many Latin American countries). Finally, emerging countries with basic problems due to the abovementioned factors, and which also have a current account deficit (they need foreign capital to sustain their level of consumption and investment) are hemorrhaging capital, to the tune of almost a trillion dollars over the last year. Moreover, if businesses in a country like have accumulated debts in strong foreign currencies, the depreciation of their own currency may make it impossible to repay such debts, which could trigger a banking crisis which may end up as an extreme crisis, as we know all too well here in Spain. Turkey, Brazil, Indonesia, Colombia, South Africa and Peru are looking at something like this.
In my opinion, the consequences of this trilogy of threats for many emerging countries could be major, and I do not rule out the possibility of one going bankrupt. Whatever the case, I can see a clear trend developing between now and 2020. It will be a time in which the differential growth between emerging and developed countries will be narrowed down to a minimum.
The numerous gurus who have been forecasting a world dominated by BRICs in which a decadent west no longer counted for anything will have to find somewhere to lie low for a while.