China is clearly in economic trouble. So how worried should everyone be about spillovers from the country’s woes to the rest of the world economy?
In general, I have been telling people “not very,” although spillover is a bigger issue for Japan and South Korea. But Citigroup economist Willem Buiter recently suggested that China’s problems could be quite a big deal for other countries, and lead to a global recession.
Is he right?
Let me start with the case for not worrying too much, which comes down to the fact that China’s economy, while big, still represents only a small fraction of the global economy – about 15 percent at market exchange rates, which both Mr. Buiter and I consider to be the relevant number. Now, we have a very old – but still useful – model for thinking about the simple economics of interdependence: the foreign trade multiplier. Imagine a world containing two countries, A and B, in which A has a recession. This will cause A’s imports from B to fall, with a contractionary effect on B. B’s contraction leads to a fall in imports from A, leading to a further slump in A’s economy, leading to still lower imports from B, and so on.
This may sound like an explosive process, but given realistic numbers, it’s actually convergent, and, in fact, the later-round effects should be trivial. Chinese imports from the rest of the world are less than 3 percent of the rest of the world’s gross domestic product. Suppose China experiences a 5 percent slump in its GDP; given an income elasticity of 2, which is reasonable, this would mean a 10 percent fall in imports – but that’s a shock to the rest of the world of just 0.3 percent of GDP That’s not nothing, but it’s not that big of a deal. However, based on episodes like the 1997-98 Asian financial crisis, my sense is that we often see a lot more contagion of economic crises than this kind of model can explain.
So what else could happen?
It’s possible that a Chinese economic slump could, via its impact on commodity prices, do a lot more harm to other emerging markets than the above analysis suggests. I’m still working on this, although so far I don’t seem to be finding much.
Another possibility is an international version of the financial accelerator. As Mr. Buiter points out, many emerging markets seem to be vulnerable thanks to private-sector foreign currency debt (which was so deadly in Asia in 1997-98). So you can imagine that a China-driven slump in exports could lead to currency depreciation, which could lead to financial troubles, which could lead to much sharper declines in GDP than a direct export multiplier would suggest.
Or perhaps we could see some version of the financial contagion that involved emerging economies in the 1990s. Troubles in Brazil might make investors leery of other emerging markets, which could then drive up interest spreads and force fiscal austerity measures that could worsen the downturn. Or for that matter, to the extent that the same hedge funds have been buying assets in a number of emerging nations, losses in one place could force them to liquidate assets elsewhere, causing a sort of global debt deflation. That was a popular story in the 1990s, and it might apply again.
Overall, I’m not convinced by the Buiter thesis; China doesn’t seem big enough to bring down the rest of the world. But I’m not rock-solid in that conviction, largely because we’ve seen so much contagion in the past.