News in Charts: China’s choice

The emerging Asian crisis of 1997/1998 illustrated the dangers of developing economies borrowing too much from abroad — with international investors taking fright and credit drying up, triggering collapsing currencies and recession in those economies. China learnt a lesson from their experience and was determined to industrialise as rapidly as they did, or more so, but without any net borrowing from abroad. The impact of that choice rippled around the global economy and led to the great financial crisis in 2008/2009, and its effects are still reverberating today.

One of the effects in the first instance was a supply of cheap credit into advanced economies during the decade ahead of the financial crisis, and its corollary, a supply of cheap exports too. Prices stayed low and interest rates stayed low in the developed world, even when developed economies were running hot. That led to a ballooning credit cycle and the crash in 2008.

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Now, developed economies are running hot again, with output at or above trend and unemployment at or below equilibrium. Normally, the result would be inflation, higher interest rates or a global recession (that is Fathom’s central forecast). But China could prevent that outcome from occurring once again, by redoubling its efforts to increase its export markets by cutting prices even further — either through a weaker currency (which is already happening) or through increased subsidies for exporters (which might be happening). This time around, it will be harder to achieve, since the price-level effects of cheap Chinese labour are already reflected in global prices, and China’s share of global manufacturing exports has already passed the peak that any other industrialising economy has ever achieved. This time, it would mean the dollar price of Chinese exports to the US (and other developed economies) falling sharply, and continuously for the coming few years, not just holding as it did ahead of the great financial crisis.

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Should that happen, inflation would not rise in developed economies, interest rates would stay low, and a recession would be avoided in the short term. But then another credit cycle would take hold, and another banking crisis — albeit a few years away still — is the likely outcome. That is Fathom’s risk scenario.

So, it’s a small amount of pain for the global economy soon; or a lot of pain, later. China will decide.

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