The International Economics Program

COVID-19 looks set to hit the emerging world hard. For Australia, what happens in India and Indonesia could be most consequential. Originally published in the Australian Financial Review.

For a second there the global economy was off to a slightly better start for 2020. The US and China finally inked an initial “phase one” trade deal that at least promised to pause hostilities for a while. That provided some much-needed respite for a world economy, which last year reached its weakest point since the global financial crisis. Shortly after, the International Monetary Fund was quick to provide a more upbeat global growth outlook, suggesting that slowing economic activity might be bottoming out.

Enter the Wuhan coronavirus. We can only speculate what ultimate impact – both human and economic – the virus will have, depending on how far it ends up spreading.

The most important channel of economic impact will likely be the hit to Chinese consumer spending. That’s less a function of the inherent danger of the virus – which is still unknown – and more about the precautionary response of the government and Chinese consumers leading people to stay home instead of heading to the shops, eating out, travelling or doing leisure activities. Other government containment efforts will also add to this – including lost output as businesses stay shut for longer following the Lunar New Year.

How big of an impact for the Chinese economy might this prove? Comparing it to the 2002–03 SARS outbreak suggests the shock could be substantial. While China’s economy continued to grow briskly through that episode, the underlying story suggests today’s experience could be quite different.

In 2003 Chinese consumption growth suffered a sharp slowdown. The economy was only able to escape a drop in headline growth because investment and exports were booming at the time, with China having entered its hyper export-led growth phase following its 2001 accession to the World Trade Organisation. The government was also able to help with stimulus measures.

This time around things are very different. Consumption is now an even more important driver of the economy while investment and exports have been weakening – reflecting China’s efforts to reduce its reliance on debt fuelled investment and pressure on the external front from the trade war with America.

There is also much less scope for sizeable stimulus today, with Chinese policymakers aiming to stabilise macro leverage in the economy in order to contain systemic financial risks. China might also be reluctant to let a weaker yuan serve as a natural exhaust valve – for fear of encouraging capital outflows but also potentially reigniting economic tensions with the Trump administration over the exchange rate. Having said that, if things worsen China’s top leadership may eventually judge that more support is needed to buttress things.

All up, if the Wuhan coronavirus crisis proves around the same scale as the SARS episode then China’s economy could conceivably be looking at economic growth dipping from the current 6.1% rate to something in the 4-5% range this year, even on the government’s rosy numbers. This is of course simply a guess. A lot of variables could influence that. A wider epidemic would spell bigger problems. Conversely, even successful government and public precautions might still impose a significant cost on the economy, if that is what it takes to halt the spread of the virus.

What might the impact be on the global economy? China accounts for about a fifth of world output on a purchasing power parity basis – the IMF’s preferred measure – meaning a Chinese slowdown to say 4.5% would directly knock off 0.3 percentage points from the fund’s latest global forecast of 3.3% for 2020 (made only last week). That alone would effectively wipe out the 2020 uptick in global growth that the IMF was hoping for, and instead keep the world economy growing at a similar pace to last year – already the slowest pace of global growth since the 2008–09 crisis.

Knock on effects for other economies could however make things worse. It is not clear how far the virus itself might spread in other countries. But the indirect effect of a sharply slowing Chinese economy would be felt by others and could be a major difference compared to the SARS experience. Not only are the risks of a sharp Chinese slowdown greater this time around but China is also now a far more important source of demand for the rest of the world, particularly in Asia.

What about for Australia? Australia’s tourism and education exports to China would appear most in the firing line. China has announced a halt to overseas tour groups. However, Australia’s tourism exports to China only amount to about 0.2% of GDP. Education exports amount to a more sizeable 0.6%. But the experience during the SARS epidemic was that education exports remained resilient, suggesting less cause for concern.

Meanwhile, the fact that the overall slowdown in China’s economy will be consumption led should help insulate Australia’s more important commodity exports from major damage (if China were to resort to renewed stimulus it could even provide some boost). Australia’s much less significant agricultural exports could however take a hit from weaker Chinese consumption.

A weaker Aussie dollar in response to increased global risk aversion and slower Chinese growth should however provide at least a partial offset – giving a boost to Australia’s international competitiveness, including tourism, education, and agricultural exports to other countries.

The economic risks for Australia therefore look less severe than some might fear.

All of this, however, depends on how far the virus ultimately spreads.

“CHINA’S GDP GROWS AT SLOWEST RATE IN 29 YEARS” bellowed the Financial Times headline last week. Never mind that this rate was still three times faster than OECD growth. The past decade has seen a relentlessly alarmist narrative about China’s slowing growth, yet China is still recording over 6%, despite US President Donald Trump’s best efforts to make life hard for them.

Let’s recall some of the forecasting failures.

Given that we have just completed the decade, it’s time to call out Beijing-based economic academic Michael Pettis, asking him to pay up on his 2012 wager with The Economist, having confidently predicted China’s growth would “barely break 3%” this past decade. You might say he was nearly half-right. The decade average was more than twice that, at 7.2%. Sure, the official figures might over-state, but the message is clear enough: his pessimism was unfounded.

In 2014, Larry Summers and World Bank economist Lant Pritchett read the tea-leaves from the global growth experience. They observed the economic equivalent of “trees don’t grow to the sky”, that eventually fast-growing economies such as pre-1990 Japan, Taiwan, Hong Kong, Singapore, and South Korea use up the opportunities for rapid technological catch-up, and growth slows to the modest pace seen in advanced economies. On this flimsy basis, they predicted “reversion to the global mean” for China, with 3.9% annual growth for the subsequent two decades.

Longer-term predictions like this can’t be quickly refuted, but China is still far from the technological frontier, and its capital stock per head is a small fraction of that in economies such as Singapore or Japan. On the basis of potential catch-up, current growth seems feasible for the next decade or two. Not inevitable, of course, but a prospect not to be dismissed on the basis of a melange of diverse global experience.

Given that China’s financial sector expanded spectacularly after 2009, initiated by its stimulatory response to the global financial crisis, predictions of financial collapse have been ten-a-penny. More definite than most, in 2015 prolific economist/author Tyler Cowen predicted imminent financial collapse, putting the economy in sustained recession. I tried to entice him into betting on this outcome, but he didn’t want to play. I never doubted his street-smarts.

More recently, Stephen Joske made a similar prediction of financial doom, although less imminent. “China’s road to a crisis became irreversible in 2015” … “They will not have two years to sort out their policies” … it is likely to occur “early next decade”. Again, this prediction made in October 2018 still has time to run. But more recent commentary sees the possibility that the financial sector can be made safer over time.

No-one disputes that the transition from poverty to riches is littered with traps and dead ends. The huge literature on the “middle-income trap” attests to this. It’s also true that just about every economy that deregulated its financial sector had some form of crisis not long afterwards. But there are enough examples of countries which have successfully made the transition to refute the idea that failure is inevitable.

You have to look at the specifics of each country. China has some factors that give it a better chance of avoiding a financial crisis. It has some of the characteristics which helped Singapore’s success: a strong interventionist government with technocratic expertise, prepared to combine the allocative power of free-markets with regulation in order to steer and discipline market excesses and inefficiencies.

Politics is crucial and this could go drastically awry. But if the focus here is just on economics, then sensible policy-making, boring though this sounds, is the key. There is no technical reason why economic cycles get old and die, as Australia has demonstrated over the past three decades.

There is similarly no in-built reason why the path from “developing” to “advanced” must be thwarted by a middle-income trap. Mechanical reversion-to-mean is not relevant in this diverse world. Indonesia’s three decades of 7% growth didn’t end in 1997 because it was unsustainable. It ended because of a series of disastrous policy mistakes.

Can China scale-up the sort of flexibility, consistency of policy focus and adjustment capacity demonstrated by Singapore? Will policy mistakes in the balance between market-forces and intrusive regulation prove to be China’s undoing? China expert Nicholas Lardy, previously an optimist, has become more pessimistic because policy choices have favoured state-owned enterprises, thus depriving China of the dynamism it enjoyed in the three decades before 2009.

There is too much focus on China’s deceleration from double-digit growth before 2009 to the present 6%. Rather than focus on the slowing, the more important issue is whether the current rate is enough to cope with the huge challenges ahead. Annual growth of 6% doubles GDP in 12 years, and today’s 6% growth represents much more in terms of actual output than the higher growth rates of earlier decades, when the GDP base was much smaller.

Sustained sensible policies would make this pace of expansion feasible, although certainly not inevitable. Gloom merchants take note.

Who dominates global trade? It is well recognised that China has become the world’s largest trading nation. Less appreciated is the effect this has had in displacing the United States from its traditional dominance as a trading partner for other countries around the world.

We examined this using data from the IMF’s Direction of Trade Statistics database, which provides a repository of bilateral trade flows for most countries. We focus on gross trade flows (i.e. exports plus imports) which serves as a measure of the degree of trade integration between two economies and ask for each country whether the US or China is the larger trading partner.

China’s rise since the turn of the century has been swift.

In 2001, the year China acceded to the World Trade Organisation, over 80% of countries with data available had a larger volume of trade with America than China. By 2018, that figure was down to a little over 30% – with two-thirds of countries (128 out of 190) trading more with China than the United States. Equally important, 90 countries traded more than twice as much with China as with America (these are shown in dark red in the chart).

The turning point was the global financial crisis, with China overtaking the United States as the larger trading partner for more than half of all countries. In recent years the trend in China’s favour has petered out as its economy has slowed while America’s has picked up. But the global trade landscape is already substantially reshaped.