Financial markets have not enjoyed the best of starts to 2016.
On the back of mounting concerns over the outlook for the Chinese economy and global energy sector, risk assets have copped a pummelling. Stocks, commodities and higher-yielding currencies have all been hit with investors scurrying to the relative safety of the sovereign bond markets to escape the ongoing, and intensifying, carnage.
China, in particular, has been at the forefront of investors’ minds. A surprise devaluation in the renminbi six months ago, rapid acceleration in capital outflows, near 50% rout in the benchmark Shanghai Composite stock index and a plethora of weak data releases has clearly dragged on sentiment.
While the markets are fretting, with some well known investors making some increasingly bearish calls, not everyone believes that a “Chinageddon”-type scenario is about to unfold, leading to a worldwide recession.
Goldman Sachs, for one, isn’t pessimistic. Far from it.
Not only does the famed investment bank believe that a continued slowdown in China will have little impact on global growth – it suggests an even steeper decline will matter little to the global economy in the year ahead.
Here’s the view of Jari Stehn, Goldman’s senior global economist, on why the risks to developed nations from an accelerated China slowdown are “probably not very big”.
The main reason is that exports to China, and more broadly to Asia ex-Japan, as a share of GDP are small—around 1%—for most DM countries with the exceptions of Australia, Japan, and Germany. This means that even if Chinese import volumes were to decline by 10% across the board due to a combination of Chinese domestic demand weakness and CNY depreciation—a very severe assumption— this would only take 0.1ppt off DM GDP growth directly.
Along with a muted impact from direct trade exposures, Stehn suggests that indirect linkages from a deterioration in the Chinese economy would do little to harm growth in developed nations based on the bank’s economic modelling.
Perhaps not surprisingly given the relatively modest trade exposures, the spillovers of either domestic demand weakness in China or a moderate exchange depreciation similar to what we have seen recently is not large, in each case below 0.1pp for all of the major economies. The impact of a domestic FCI tightening in China is also not very large, owing primarily to the typically limited pass-through from domestic Chinese financial markets to the rest of the world. Implications of any of these shocks for either inflation or policy rates in partner countries are likewise relatively small.
Based on analysis conducted by Goldman involving the renminbi and Chinese financial conditions in the year ahead, Stehn suggests that under even the most adverse scenario for the Chinese economy – a drop of two percentage points in domestic demand, no change in the value of the renminbi and a significant tightening in financial conditions – the “spillovers into developed market economies appear manageable”.
Its expected impact on economic growth for the US, Eurozone, Japan and China is shown in the chart below under the “currency defence” scenario.
As for the recent turmoil that has gripped financial markets – largely centred around the outlook for the Chinese economy hence global growth – Stehn suggests that the sell-off in US stocks may “overstate the headwinds facing the real economy”.
While Stehn isn’t convinced that recent sell-off in risk assets points to a sharp slowdown in growth in the period ahead, he cautioned that concerns in financial markets could, if sustained, end up impacting on the real economy, something that US Federal Reserve chair Janet Yellen stated overnight.
“The markets can create their own reality, at least up to a point, via the sharp tightening in financial conditions, so it is important to watch this indicator closely,” says Stehn.