Weathering the American Contagion

Posted December 28, 2008

There’s long been talk of a decoupling of developing countries and emerging markets from the U.S. economy. Some even set their hopes in a reversed decoupling, meaning that big emerging economies like China could take over as engines of world growth and pull the U.S. forward. It is now evident that this was wishful thinking. The U.S. already has the flu, Europe and Japan have been infected, and there is no way that the rest of the world’s economies will get by unscathed.

China, like the rest of the emerging economies, has not decoupled. The Chinese economy had already started cooling down last year, not least because of government attempts to move the economy toward the higher end of the value chain. The downturn has now been exacerbated by the global financial crisis. While the direct financial contagion effects on China have been small, thanks to a largely closed banking sector, China has been hit through crumbling exports and dried-up investment flows from abroad. The European Union and the U.S., China’s two most important export markets, are both in recession.

Moreover, because of the yuan’s peg to the dollar, China has seen its currency strengthen against major trading partners and competitors, reducing the competitiveness of Chinese exports. According to Chinese customs figures, Chinese exports declined 2.2% and imports fell 17.9% in November, compared with a year earlier. In 2007, exports still grew by a staggering 25%. With economic contraction worsening in America, Europe and Japan and a slowdown of growth across East Asia, Chinese exports are set to deteriorate further. And worryingly, the deep fall in imports points to weakening domestic consumption, suggesting that the Chinese are not ready to take over the American consumer’s role as buyer of last resort.

In its latest growth projections for developing Asia, the Asian Development Bank expects the region to grow by 5.8% in 2009, the lowest growth rate since 2001 and down from its earlier forecast of 7.2%, released in September. The ADB’s current growth forecast for the next year for China is 8.2%, but further downward revisions can be expected. To some these projections seem overly optimistic—pessimists fear that China could grow as little as 5.5% in 2009, which would be almost half its 20-year average growth rate of 10%. Given that China accounts for only 6% of the world economy it is hard to see how China could drive world growth and lift the U.S. and Europe out of their slump.

The global crisis hits China at a critical juncture. The government has progressed only halfway in its attempt to shift resources in the prospering coastal provinces from low-end manufacturing like apparel and toys to the production of more sophisticated goods and high-tech industries, and at the same time relocate the low-value exporting sector to the poor Western provinces. As a consequence of the export crisis, millions of migrant workers are now losing their jobs. The bursting of the equity and property bubbles that had developed in recent years has also hurt the economy, though not as severely as in the U.S.

It was clear already before the global financial crisis that the Chinese economy would have to rely more on domestic demand to get on a more balanced growth path. Its dependence on exports—which has increased the economy’s vulnerability to external shocks and exposed it to the downturn of the global economy—has proven to be the Achilles heel of Chinese growth. In addition, providing cheap credit to the U.S. to finance American imports from China has also proven unsustainable.

At this December’s annual economic policy conference the Chinese government made clear that it is determined to pull out all the stops to avoid a sharp downturn of the economy. In November it announced a fiscal stimulus package of four trillion yuan ($584 billion), about 2% of the country’s GDP. This bold decision won wide praise, although parts of the package include measures that had been announced beforehand.

Much of the money is designated for investment in infrastructure—for instance roads and railway tracks—that will improve the country’s growth potential, especially of the less developed Western provinces. The crisis will thus act as a catalyst to upgrade the country’s industrial infrastructure. Thanks to prudent government spending over the last years and vast foreign-exchange reserves, China is in a fiscal position that will allow it to further increase spending if the domestic slowdown worsens. Also, the banking sector is still state-controlled, which gives the government the ability to direct lending (something most market economists would typically despise, but which seems quite handy in a situation where Western governments helplessly try to encourage banks to extend credit to firms). Yet it is questionable whether all the spending can be deployed quickly and effectively enough to cushion the short-term effects of the crisis.

Boosting consumption and reducing hardship for those who lost their jobs could be facilitated by an improvement of the country’s safety net. Much remains to be done here. Better pension schemes and unemployment insurance will help reduce the country’s ridiculously high savings rate and stimulate domestic demand. Especially for the millions of migrant laborers, many of which are now facing unemployment, better social provisions are urgently needed. Migrant laborers, who have served as cheap input for the country’s export sector and as such have been key to China’s export success, lack the permanent residency status that would entitle them to full medical and education benefits.

President Hu Jintao has said that the best thing China can do for the world economy is to keep growing. This would certainly help stabilize the world economy, but there is more China could and should do. In particular, China should coordinate more closely with its East Asian neighbors in containing the crisis. China has already expanded currency swaps to South Korea. It is also understood that China is ready to step in if other neighbors, such as Indonesia or Vietnam, will need emergency credit to finance a current-account deficit and fend off a currency crisis.

Yet China could and should do more. In May this year the ten Southeast Asian countries together with China, Japan and South Korea agreed to create a regional reserve fund worth $80 billion, building on a system of bilateral foreign-exchange rate swaps that was set up after the Asian financial crisis of the late 1990s. In November they reaffirmed their commitment at the ASEM summit. But instead of using the opportunity of the moment to let deeds follow words they postponed negotiations until the spring.

 Creating such a regional reserve fund now would send a clear signal that East Asian monetary and financial cooperation is more than mere talk. At the same time, it is important that China coordinates exchange-rate policies with the other Asian countries to avoid beggar-thy-neighbor policies and a protectionist backlash. If China can help the other East Asian economies to weather the current storm, it truly will have contributed to stabilizing the world economy.

Ulrich Volz is a senior economist at the German Development Institute.