Fed May Fly into Slack Over China, Greece
Global economy may be more at risk than global markets
By Justin Lahart
July 9, 2015 12:43 p.m. ET
An employee works at a Shuangwei factory in Putian, Fujian province, China. Photo: John Ruwitch/Reuters The real global threat from China and Greece may not be financial-market contagion, but economic contagion.
Investors around the world have had a rough time lately. With Shanghai shares swooning and Greece running out of money and looking for a bailout, stock markets have been taking it on the chin.
Despite the severity of what is happening, the cascading losses seen in financial-contagion episodes haven’t occurred.
Perhaps it is just a matter of time. But global investors don’t appear to have put on the leveraged bets—buying assets with borrowed money—that have gotten them into trouble in the past. This is partly because current problems are wholly unforeseen risks. Moreover, following the 2008 crash, investors and banks have taken more care with leverage, and regulators have kept a closer watch.
But troubles in China and Europe may have economic consequences that can’t so safely be ignored. With global demand already falling well short of potential supply, there is a risk they could have a chilling effect on both growth and prices around the world. What’s more, with short-term interest rates already extremely low in most developed countries, central bankers have limited capacity to heat things up. And any need for additional firepower could cause the U.S. Federal Reserve to hesitate on raising rates from zero levels later this year or do so at an even more cautious pace than many expect.
The big concern is China. Its economy was already slowing before the stock market tumbled.
Official figures put gross domestic product up 7% in the first quarter from a year earlier, versus a 7.4% increase in the year-earlier period. Lombard Street Research economist Diana Choyleva calculates growth was an even cooler 3.6%, and thinks the boom in Chinese stocks this year was encouraged by officials who saw it as a way to support growth. That has backfired. Now, there is a risk outside investors will question the future pace of market reform in China, while people in China will put less trust in the financial system. Both could weigh on the economy.
Greece could similarly slow Europe’s economy. Its travails may shake confidence in the euro, while financial and fiscal conditions in countries like Spain will likely get tighter. All told, economists at J.P. Morgan estimate 1.5 percentage points could get shaved off of GDP in the remaining eurozone countries over the next 18 months.
This potential one-two punch lands as the global economy is already dealing with a great deal of slack.
Eurozone unemployment was 11.1% in May versus 7.3% at the start of 2008. Manufacturing capacity utilization in the second quarter came to 81.1% versus 84.4% in first quarter of 2008. That is a big reason inflation is so low there, and why the European Central Bank stepped up bond purchases earlier this year.
The poor state of China’s economic data makes it impossible to get a bead on how much spare capacity exists there. But evidence suggests it is running high.
The Chinese steel industry, for example, built out capacity under the assumption the economy would continue growing at a double-digit pace, and can now churn out far more steel than the country needs. That is part of why benchmark steel prices have fallen by nearly a third over the past year. China’s capacity glut is weighing heavily on raw materials prices, too.
Weaker European and Chinese growth could make the slack even more pronounced. Layer in further euro weakness and China stepping up exports to bolster its economy, and inflation globally could get even cooler. So could growth, as producers away from China and Europe struggle to compete on cost.
The world’s other major economies—the U.S., the U.K. and Japan—are now in good enough shape they should be able to handle the headwinds. But their central banks might have to keep policy looser for longer.
As China and Greece have shown, bad things can happen.
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