September 8, 2015
China has spooked investors. What has been happening on financial markets for over a month, since the speculative bubble burst in Shanghai, is reminiscent of the onset of the great recession in 2008-2009, especially when coupled with the decline in crude oil prices, which is widely perceived as a harbinger of recession. The standard explanation is that the current decline is linked to flagging demand in China, which may drag down the global economy. To make matters worse, what appears to confirm this bleak scenario is the close correlation between the oil market and stock markets, which have seen the largest slumps since 2009, not only in China, but also in Europe and the majority of emerging economies.
I believe China does not threaten the global economy and declines in oil prices do not predict a recession. If we look at China and the oil market from a wider perspective to identify causal relationships, we will see that China is finally on its way to long-expected normality. Its rate of economic growth is slower compared to historical highs, but the slowdown is rooted in changes in Chinese demand and production structures, which are going in the right direction and are typical of transforming economies. Just like in Poland in the early 1990s, the share of consumption and domestic market in demand is growing. On the production side, the process is reflected in the rising share of services. Consumption and related services are less capital- and energy-intensive than investment projects and industry, although they require more labour. In effect, demand is falling for raw materials, but growing for consumer goods and services, most of which are produced domestically. When consumption starts to drive demand, direct interventions into economic processes become more and more expensive, as the Chinese authorities have had the opportunity to learn, and will be abandoned eventually. China’s road to a market economy has been long and twisted, but the fact that the country is most likely already on this road is good news. The fast progress of the manually-controlled giant, dragging the rest of the world along a track lubricated by financial markets, has sparked a crisis and serious global recession. Luckily, the scenario is unlikely to repeat itself. Over the next 20-30 years there is no country which would be able to agitate the global economy to such an extent as China did.
Enter the dragon and global imbalances
The last 15 years in the global economy were a time of the dragon. China’s accession to the World Trade Organisation (WTO) in December 2001, which happened amid the chaos which broke out on international markets in the wake of the 9/11 attacks on the World Trade Center, opened its way to safe investment and trade. The impulse came when it was very much needed – at a time when synchronised recession had in its throes the world’s three largest economic hubs: the US, Japan and the European Union. Poland also saw a sharp economic downturn in 2001, with its growth rate shrinking from some 4% in 1999-2000 to 1.1% in 2001.
Gathering momentum thanks to an inflow of capital and production, and a subsequent outflow of finished products to investors’ markets, the Chinese economy has become not only a driver of global economic growth, but also a source of problems far beyond the country’s borders. American and European consumers were eager to buy goods made in China, which were offered at competitive prices. In consequence, the trade deficit in the US and other developed economies, and the trade surplus in China, began to grow. As China invested its funds on the American financial market, which was the most developed, increased demand for US bonds further eroded their profitability, turning the securities into a cheap way of financing the US budget, which was stretched thin by the growing cost of the war declared by the US on Islamic terrorists. Global imbalances (rising debt in the US and developed countries and higher savings in China) became more and more pronounced amid low interest rates, which continued for a long time thanks to cheap consumer imports from China. In the meantime, low interest rates encouraged the pursuit of profit and contributed to the dynamic development of increasingly more risky financial instruments, tied to the rapidly growing prices of property (resulting from cheap mortgages) and the expansion of the financial sector.
Oil prices and economic growth
The low cost of capital in developed economies and cheap labour in emerging economies have contributed to rapid industrialisation and development of the latter, in addition to accelerating global economic growth. Since the ever growing number of China’s factories needed electricity, and it would take several years to construct a coal-fired power plant, diesel generators were used. The demand for crude oil was also stimulated by intercontinental sea freight transport. Prior to its accession to the WTO, China’s economy grew at an annual rate of 10.8% and accounted for 20% of global oil demand growth (5-year average). Over 2001-2005, China’s growth rate stepped up to 11.4% (despite global deceleration), while the country’s share in global oil demand grew to 25%. Over the next five years, between 2006 and 2010, despite of the great recession, China’s economic growth rate increased to 13.5%, and its share in global oil demand swelled to two-thirds (66%).
In response to this surge in demand from China, crude oil prices, which in 2001 stood at USD 24 per barrel (Brent crude), began to grow rapidly (USD 38.2/bbl in 2004, USD 54.5/bbl in 2005, USD 72.4/bbl in 2007), eventually causing an increase in inflation and interest rates, and the rising cost of credit became a direct trigger of the financial crisis (interest rates in the US began to rise in June 2004, from 1% to 5.25% in July 2007).
Let’s now go back to the relationship between crude prices and recessions I have mentioned earlier. This interrelation is discussed by Anatole Kaletsky. Falling oil prices were never indicative of an upcoming recession. In the past, each time the price of oil decreased by half (1983-1983, 1985-1986, 1992-1993, 1997-1998, and 2001-2002), global economic growth accelerated, and all global recessions in the last 50 years were preceded by a sudden increase in crude oil prices. The last time the price of crude nearly tripled (from USD 50/bbl to USD 140/bbl) was in 2007-2008 – just before the global crisis broke out. The price then fell to USD 40/bbl over the next six months – directly before the economic recovery began in April 2009.
The negative correlation between oil prices and global economic growth is rooted in a powerful economic mechanism. As the world consumes 34 billion barrels of oil each year, a USD 10 drop in crude prices corresponds to a shift of USD 340bn from oil producers to consumers. Therefore, the decrease of USD 60 in the period from August last year will translate into savings of over USD 2tn for oil consumers, which represents a greater influx of money than from the US and Chinese 2009 economic stimulus packages combined.
As oil consumers tend to spend the additional cash relatively quickly, while governments (which collect the bulk of global oil incomes) typically finance public spending from loans and by tapping into reserves, the net effect of lower oil prices is always conducive to global growth. To once again reference the calculations by the International Monetary Fund, this year’s decrease in crude oil prices, other things being equal, should boost global GDP in 2016 by 0.5-1% (0.3-0.4% in Europe, 1-1.2% in the US and 1-2% in China).
So what will happen to China?
Following the 2008-2009 crisis set off by uncontrolled adjustment of global imbalances, stabilising the global economy became the key issue. To this end, consumers in the US should save more, while those in China – spend more. And this is what is currently happening, causing the Chinese economy to decelerate. Although the process will not be smooth, many economist believe that there is little risk of a hard landing. China is taking its first steps on a bumpy road to normality, which is taken to signify an economic growth rate of 5-6% over the long term. It appears that the economic wonder of China, which was a mixed blessing for the global economy, will not happen again any time soon. To me, this is good news.