How US and European recession risks could play out for China

Given China’s close trade ties with the US and Europe, weakening demand in those markets will have an obvious impact on the Chinese economy
Also, China’s financial markets will not be immune to the external volatility induced by US recession fears

Aidan Yao

Published: 3:30am, 22 Sep, 2022

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The US and European economies have staged impressive post-pandemic recoveries, but both are now showing signs of significant fatigue. The slowdown has been driven in part by food and energy price shocks that required their respective central banks to withdraw policy stimulus to quell multi-decade high inflation. With the Federal Reserve and European Central Bank now undertaking tightening in slowing economies, fears of policy overshoot and economic hard landings have risen.

Slowing demand in two of the world’s major economies could have far-reaching ramifications. China is particularly vulnerable, given its still close trade ties with the United States and Europe – despite the US-China tariff spat – and a growing dependency on foreign capital thanks to its recent financial market liberalisation.

From an economic standpoint, trade remains the most obvious channel through which weakening external demand can impact China. An examination of China’s exports to the US shows that all three US recessions in the past two decades – the recession in 2001 after the dotcom bubble burst, that in 2008-9 during the subprime crisis, and that in early 2020 immediately after the pandemic broke out – have coincided with sharp declines in China’s shipments to the US.

Looking at the Organisation for Economic Cooperation and Development’s trade in value added (TiVA) data, which traces one country’s true export exposure to another’s adjusted for supply-chain effects, one can estimate the quantum of impact that several landing scenarios for the US and Europe will have on China. In the case of a soft landing, in which the US and European economies slow down but avoid recession, China’s exports to the two markets will weaken accordingly but also avert an outright contraction. This will see its export contribution to gross domestic product growth fall by half relative to 2021 levels.

In the case of a hard landing, with the two economies slipping into mild recession, China’s exports are likely to contract, shaving 0.3 per cent off gross domestic product in the next 12 months. But if they crash-land into deep recession – like during the global financial crisis – the export shock alone could cost one percentage point of China’s GDP.

It is important to note that the above estimates assume all else being equal. In reality, this is unlikely to be the case. In the face of a severe external shock, the Chinese authorities can hardly be expected to stand idly by. Indeed, movements in China’s “credit impulse” – which measures the change in new financing as a share of GDP and is a proxy for the effectiveness of monetary policy – have historically been in lockstep with the rise and fall of export growth, easing when activity slows and tightening when it is strong.

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Fiscal policy has also played a counterbalancing role. Since 2008, all three periods of major fiscal expansion in China have coincided with declining export growth. Conversely, periods of strong external performance have seen the authorities withdrawing stimulus. These patterns suggest Beijing is quite likely to step up policy easing should both its major trading partners slide into recession together.

Finally, China’s financial markets will not be immune to the external volatility induced by US recession fears. One could argue that the impact is already visible in the foreign exchange market, with a skyrocketing dollar – bolstered in part by safe-haven flows – putting significant pressure on the yuan-dollar exchange rate.

As the yuan approached the psychologically important 7 per dollar mark, the People’s Bank of China took action to stem depreciation, by setting stronger currency fixing rates and cutting the amount of foreign-exchange deposits banks need to set aside as reserves.

While these actions may help to slow the rise of the yuan-dollar rate, they are not enough, nor are they intended, to reverse the market trend. As risk aversion continues to climb – driven by concerns over policy overtightening and hard landings – the renminbi may continue to struggle against what seems to be an unstoppable dollar in the near future.

In fixed income markets, movements in long-term bond yields in the US and China have shown a decent correlation. Currently, 10-year US Treasury bonds offer a yield premium over their Chinese counterparts, reflecting the divergence in monetary policy. This points to upside risks for Chinese interest rates, although weak local economic conditions and the central bank’s policy easing may put a lid on rate rises.

Finally, strong co-movements are seen in the US and Chinese equity markets during US market downturns. In fact, the offshore market – with the MSCI China index as a proxy – has tended to underperform the S&P 500 index during past US recession-induced sell-offs, while the onshore A-share market has fared better. The same pattern is unfolding in the current cycle.

Overall, with growing risks of hard landings for developed economies, Beijing needs to get prepared for an external shock. Next year could be even more challenging if the export engine sputters and the domestic economy remains in the doldrums. After the party leadership reshuffle, markets will be looking for substantial policy changes to put China’s development on a more sustainable path.

Aidan Yao is senior emerging Asia economist at AXA Investment Managers