Worries About China

Paul Krugman is among those starting to be concerned about an economic downturn in China. Here are my thoughts on this issue.

Let me begin by clarifying that I am not reacting to the recent modest slowdown in China’s growth rates. If the issue is whether China’s real GDP is “only” going to grow at a stunning 7% rate, there’s not much to be concerned about. What rings alarm bells for me is the recent sharp spikes in interbank lending rates. Despite the official explanations, such moves could definitely be signaling some financial fragility.

Overnight Shanghai interbank offer rate, Jan 4 to July 25, 2013. Data source: Shibor.org.

Paul Krugman writes:

Suppose that those of us now worried that China’s Ponzi bicycle is hitting a brick wall (or, as some readers have suggested, a BRIC wall) are right. How much should the rest of the world worry, and why?

I’d group this under three headings:

1. “Mechanical” linkages via exports, which are surprisingly small.
2. Commodity prices, which could be a bigger deal.
3. Politics and international stability, which involves some serious risks.

To Paul’s list, I would add a fourth: financial linkages. If there are significant disruptions to China’s system for funding credit, that could have implications for anyone borrowing from or lending to Chinese entities. On the former, I am not sure of the foreign exposure for example to loans collateralized by nonexistent exports. On the latter, I think a strong case can be made that rising interest rates in China have been one reason for higher mortgage rates in the U.S.. In any case, it may be a mistake in the world of modern global finance to assume that what happens in China, stays in China.

I’d also like to add an observation to Paul’s second point involving commodity prices. A significant economic downturn in China could well mean a collapse in oil prices. One would think that, as a net importer, this would be an overall favorable development for the United States, and certainly it would be a significant plus for many individual U.S. firms and producers. But it’s worth remembering what happened after the collapse in oil prices in 1986. In the years leading up to that, just as today, there had been a dramatic economic boom in the U.S. oil-producing states, as oil producers invested heavily in more expensive projects. When oil prices collapsed, domestic producers took a significant hit. The labor and capital that had specialized for that sector can not costlessly move to other regions and activities.

It’s interesting to see for example what happens when you apply the recession-recognition algorithm that Econbrowser regularly updates for the U.S. economy to data for employment growth in individual states. I did this exercise as part of the background research for a study I conducted with Michael Owyang of the Federal Reserve Bank of St. Louis that recently appeared in the Review of Economics and Statistics (working paper version here). The graph below cycles through the inference for each state as we move from the first quarter of 1984 through the second quarter of 1987. Dark blue indicates strong evidence of expansion in that state for the indicated quarter, while the brighter the shade of green, the stronger is the statistical confidence that the indicated state was in recession at that time. Plunging oil prices were good news for much of the nation, but sent the U.S. oil-producing states and their neighbors into their own regional recession. This also contributed to the savings and loan crisis that the U.S. experienced at the time.

My bottom line: China is worth watching.