China to lead world into moderate recession

WE believe that a moderate global recession scenario has become the most likely global macroeconomic scenario for the next two years or so. The most likely scenario in our view for the next few years, with a 40 per cent probability, is that global real gross domestic product (GDP) growth at market exchange rates will decline steadily from here on and reach or fall below 2 per cent around the middle of 2016.

Growth is likely to bottom out in 2017 and start recovering again from late 2017 or early 2018. The output gap could be closed, meaning the world exits recession, in late 2018 or 2019.

The evidence for a global slowdown is everywhere. Global growth has been weakening since 2010. A modest pick-up in GDP growth in the developed markets (DMs) since 2012 is swamped by a sharp decline in emerging-market (EM) growth.

There are other informative indicators of global weakness, notably the very weak - indeed negative - world trade growth in the first quarter of 2015.

There is also the continued weakening of real commodity prices, the weakness of the global inflation rate (measured by the GDP deflator), the recent decline in global stock prices, plus indications that corporate earnings growth is slowing down in most countries, and the unprecedented decline in nominal interest rates.

The slowdown in world trade has hit EMs particularly hard.

Emerging-market weakness

The main driver of global underperformance during the past two years has been EM weakness.

No EM of any significant size has outperformed our forecasts since the beginning of the year or earlier; most are underperforming.

The most significant underperformer is China. Our best guess of the "true" growth rate of real China GDP is probably somewhere around 4 per cent now.

This is based on our version of the Li Keqiang index (rail freight tonnage miles growth, electric power consumption growth and the growth of total social funding), subjectively adjusted for the growing weight of the services sector.

Other activity indices also overwhelmingly suggest an economy in which the growth of industrial production and capital expenditure is slowing down rapidly.

Consider the onset of a recession in the second half of 2016 in China, defined by us as growth of "true" real GDP growth of 2.5 per cent or less for a year or longer starting from the middle of 2016.

If the official data remain as distorted and biased to the same degree as currently appears to be the case, that would correspond to something like official GDP growth at 5 per cent or less for a year or more starting in H2 2016.

The reasons behind China's downturn and likely recession are familiar from the long history of business cycles everywhere: rising excess capacity in a growing number of sectors, excessive leverage in the private sector and episodes of irrational exuberance in asset markets - in China there were two thus far, for residential real estate and equity - resulting in booms, bubbles and busts.

This is the classical recipe for a recession in capitalist market economies. This time is unlikely to be different for China.

Policy options to prevent a recession exist but are, in our view, unlikely to be exercised in time.

Should China enter a recession - and with Russia and Brazil already in recession - we believe that many other EMs, already weakened, will follow, driven in part by the effects of China's downturn on the demand for their exports and, for the commodity exporters, on commodity prices.

Policy response in EMs

The policy response to the unfolding recession in the EMs is likely to be mostly inadequate.

Many large EMs have high private sector leverage. Even in this crowd, China stands out both because of the level of the ratio of private non-financial debt to GDP and because of its continuing rapid rise.

Korea's private debt-to-GDP ratio too continues to rise steadily. In key advanced countries such as the United States, Japan and the UK, the private debt-to-GDP ratio has come down.

The ratio has also come down in Japan since the early 1990s, following its financial crisis, and in the US, the UK and the euro area since the crisis.

The levels remain, however, disturbingly high, and would create serious private debt servicing problems but for the extraordinarily low level of interest rates.

There is a long history of bad private debt held by entities that are deemed too systemically significant or too politically connected to fail migrating to the balance sheet of the public sector.

China's public debt burden, although likely somewhat understated because of incomplete data, is nevertheless manageable when looked at in aggregate on its own.

There are, however, two reasons for the Chinese fiscal authorities not to feel too relaxed.

The first is that most of this debt is owed by local and provincial governments, many of which don't have the discretionary recurrent revenue sources (local real estate tax, local land tax, local income tax) to service that debt.

Second, the soaring non-financial private sector debt burden and the matching soaring banking and shadow banking sector balance sheets suggest that a future financial rescue of systemically important and/or politically well connected insolvent private entities and state-owned enterprises (SOEs) by the central government is likely.

This could seriously strain even the fiscal capacity of the central government.

It is likely that attempts at exchange-rate depreciation will be part of the policy response of many of the adversely affected EMs.

If most EMs end up pursuing similar competitive depreciation policies, the US could end up as appreciator of last resort, with the effective exchange rate of the US dollar strengthening significantly.

If the European Central Bank (ECB) and the Bank of Japan also pursue policies that weaken the euro and the yen respectively, there could be material damage to the US recovery, both through the trade channel and through the stockmarket valuation of US firms operating and competing in global markets and competing at home with competitors whose currencies have weakened.

Policy response in China

The policy response to the weakening of domestic (and external) demand in China is likely to be too little and too late.

China is not a command economy or a centrally planned economy - indeed, unlike the former Soviet Union, it never was.

Like most real-world economies today, it is a messy market economy of the state capitalist or crony-capitalist variety, where policy ambitions are not matched with effective policy instruments and where macroeconomic management and financial crisis prevention and mitigation competence are in short supply.

The mishandling of the housing boom, bubble and bust, and of the latest stock market boom, bubble and bust together with the recent renminbi kerfuffle don't inspire confidence in the ability of the authorities to prevent a cyclical hard landing for China.

Even if, at this late hour, a fiscal stimulus is undertaken immediately to avoid a recession in 2016, it will do no more than postpone the recession and increase its depth and duration unless:

(1) the composition and funding of the fiscal stimulus are appropriate (and unlike anything seen in China in the past) and

(2) the authorities end the financial "extend-and-pretend" game and restructure the balance sheets of the over-leveraged and often crypto-insolvent SOEs, local governments and banks.

Excess capacity in the construction sector and in the traditional manufacturing sectors (not just those dominated by SOEs), the excessive leverage of the corporate sector and the local government sector, the unwillingness of the central government to tackle the suppressed insolvency of many local governments and much of the banking and shadow-banking sector, and the luxury consumption and investment demand-weakening effect of the continuing anti-corruption campaign are the factors that, in our modal scenario, push China into recession and take the world with it.

Monetary and credit policy have limited power to boost aggregate demand, in part because the corporate sector is highly leveraged and the banking and shadow banking system have extremely weak balance sheets.

The construction sector is unlikely to be a major contributor to aggregate demand in the near future.

There still is an overhang of unsold residential and commercial property. This coincides with a shortage of affordable housing or social housing, which will become especially acute if the government makes good on its plans to give more urban immigrants full urban hukou.

Without central government funding, the social need for additional affordable housing will not be translated into effective demand for affordable housing.

Residential property prices are rising again in tier-1 and tier-2 cities, but remain stagnant at best in the lower-tier cities.

With the global economy slowing down and China having lost its status as the low cost manufacturing hub of the world because of rapidly rising unit labour costs and the continuing close link between the appreciating US dollar and the renminbi, the chances of an export-led recovery are minimal.

Fiscal policy can undoubtedly come to the rescue and prevent a recession in China.

The first-best would be for the central government to issue bonds to fund this fiscal stimulus and for the People's Bank of China (PBOC) to buy them and either hold them forever or cancel them, with the PBOC monetising these Treasury bond purchases.

Such a "helicopter money drop" is fiscally, financially and macro-economically prudent in current circumstances, with inflation well below target and likely to fall further.

A total boost to public spending or cut in tax revenues of around 3 per cent of annual GDP (around US$360 billion at market exchange rates), spread over a year, would be a good place to start.

As regards the composition of the fiscal stimulus itself, some additional, carefully selected infrastructure investment in projects that assist and support urbanisation would be desirable. A boost to public or private consumption would be highly desirable. The central government could spend much more on health, education and social support.

Transmission to advanced economies

The transmission of China's recession, and the wider EM recession, to the DMs will be through trade, through commodity prices, through the asset and credit markets and financial flows, and through direct confidence contagion.

At market exchange rates - for the purpose of determining the impact on global activity rather more relevant - China's share of world GDP was 13.3 per cent of GDP in 2014, against 23.7 per cent for the European Union (EU) and 22.4 per cent for the US.

China accounted in 2013 for 14.3 per cent of global trade, against 15.7 per cent for the EU and 13.5 per cent for the US.

China has been a huge saver for decades and has accumulated a large gross stock of foreign assets and a significant net foreign investment position.

Should economic and financial distress in China cause public and private investors to unload a material share of their holdings of foreign fixed income assets (such as US Treasuries) or of foreign equity and real estate, this could have a major impact on asset prices and yields.

For technical or political reasons, most DMs have limited stabilisation ammunition at hand.

One ray of light is that most advanced economies are net commodity importers.

However, expansionary monetary policy in the US, the UK the eurozone, Japan and most smaller advanced economies is operating in the zone of severely diminishing returns.

When it comes to fiscal policy, it is clear that in the US, the eurozone, Japan and the UK, a significant fiscal stimulus would, despite the current low interest rate environment, threaten the creditworthiness of the sovereign unless the additional sovereign debt issued were bought by the central bank and held permanently or cancelled.

Such a combined temporary fiscal stimulus and permanent monetisation (or "helicopter money drop") is, in our view, only politically feasible in the UK at the moment.

We expect to see QE (quantitative easing) #N, where N could become a large integer, as part of the monetary policy response in the US and the UK, and QE2 in Japan.

The ECB will likely have to continue its asset purchases beyond September 2016 and it may cut its policy rates further.

All this will not be enough to prevent most advanced economies from performing worse in 2016 and 2017 than in 2015, and worse than our current forecasts for the next two years.

The world appears to be at material and rising risk of entering a recession, led by EMs and in particular by China. This should not come as a surprise. Capitalism is cyclical - and always has been.

It is likely that this recession will be shallower than the last one.

Helicopter money drops in China, the euro area, the UK and the US, and debt restructuring in the corporate, local government and banking sectors in China, in the private non-financial, banking and government sectors in the euro area, and in the banking sector in the UK, can mitigate and, if implemented immediately, prevent a recession during the next two years without raising the risk of a deeper and longer recession later.

There are two risks that could worsen the outlook.

The first is that we get another systemic debt crisis, in DMs, in EMs or both. Both EMs and DMs remain very highly leveraged. In many advanced countries, the public debt burden is higher than it has ever been except during and in the aftermath of major wars, when the political economy of spending cuts and tax increases was very different. Combined public and private non-financial gross debt burdens are at a record high. In many EMs, private leverage has soared.

We simply don't know much about how to engage in effective macroeconomic stabilisation in highly leveraged environments, or how to manage a financial crisis and limit the immediate damage it does without increasing the likelihood and the magnitude of the next crisis, and bringing it forward.

The track record of the supervisory and regulatory authorities, central banks and finance ministries in most DMs (and in all large DMs) before, during and since the great financial crisis has been poor. For some of these actors, this may have been because of political constraints, beyond their control, on their ability to act.

Many of the supervisory, regulatory, monetary and fiscal authorities in the EMs are untested in a severe financial crisis.

The last time we faced a situation like this, there were, outside Japan, policy interest rates that could be cut, and most countries had more fiscal space. Today, the interest rate is out of commission as a policy instrument in most DMs and fiscal space is more severely constrained than in 2008 almost everywhere.

The second risk is that the world lapses into protectionism.

Competitive devaluations (currency wars) by themselves would not damage the global recovery. When every nation tries to devalue its currency against every other currency, all will fail.

Even then, however, the uncoordinated attempts to depreciate each currency against all others will produce a globally expansionary set of national monetary and credit policies.

If, however, protectionist measures other than competitive devaluations are resorted to support and boost national economic activity, things could get much worse and stay that way for much longer.

If the right combined monetary and fiscal stimuli are implemented immediately, a recession in 2016 can be avoided. Even the belated application of helicopter money drops in the cyclically afflicted countries can ensure that the coming bout of cyclical stagnation does not worsen the problem of secular stagnation.

If, during and following the global recession, significant debt restructuring takes place in both EMs and DMs, and in both public and private sectors, we can look forward to a more durable and robust recovery after the next recession than we had following the last one.

If in addition the necessary structural reforms of labour markets, professions, product markets and financial markets are initiated in a serious manner, if we can move from rule by law to rule of law in some key countries and from rule by lawyers to rule of law in others, if structures, institutions and policies are adapted to rapidly changing conditions, then future potential output growth will be enhanced and secular stagnation avoided.

We are not holding our breath.

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