Investment Insights. How important is China to the world? Introduction. China s spillover effects

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1 Investment Insights How important is China to the world? November 2011 Introduction It is well-known that China is playing a more important role in the development of the world than it was a decade ago. But in what aspects is China influencing the world economy and financial markets and how significant is she at the current stage? This paper gives an overview of the Mainland s spillover impacts on global growth, primarily via global trade, strong commodity demand, RMB appreciation, her current rebalancing process to a consumption-driven economy, and foreign exchange reserve diversification. China s spillover effects China's power on the world stage has been rising rapidly over the past decade. The country s economic strength as well as its persistent integration into the world economy have increased its spillover effects to the rest of the world. In fact, China is currently impacting the world mainly through (1) global trade, (2) commodity demand, (3) RMB appreciation, (4) macro rebalancing process, and (5) forex reserve diversification. (1) Global trade With the capital account still largely closed, the major channel of China s spillovers to the rest of the world is through international trade. China is now the first or second largest trading partner of 78 countries in the world. The Mainland is particularly important to its regional peers as 37% of China s exports go to Asia ex-japan and 48% of China s imports come from Asia ex-japan (see Chart 1), with over 10ppt of both year-on-year export and import growth year-to-date stemming from Asia ex-japan (as of September 2011). Chart 1: China s exports and imports Chart 2: China s impacts on low income countries Source: CEIC, Morgan Stanley Research Note: NJA - non-japan Asia; Row - rest of world Source: UN Comtrade, UNCTAD, IMF The information contained in this document does not constitute investment advice, or an offer to sell, or a solicitation of an offer to buy any security, investment product or service. Informational sources are considered reliable but you should conduct your own verification of information contained herein. Investment involves risk. Past performance is not indicative of future performance and investors may not get back the full amount invested. Funds which are invested in emerging markets and smaller companies may also involve a higher degree of risk and are usually more sensitive to price movements. Please refer to the relevant offering document(s) for details, including the risk factors before investing. This document has not been reviewed by the SFC. Issued by JPMorgan Funds (Asia) Limited. 1/5

2 China s rising demand for imports has also boosted both trade and foreign direct investment (FDI) in low income countries (LICs), helping them to develop infrastructure as well as increasing their manufacturing capacity. China s share of trade in LICs has almost trebled since 2000 to 14% in 2009, about half of the combined shares of the US and Europe. China is also among the top 3 export destinations for nearly 30% of LICs, versus only 8% in 2000; over 80% of these exports are fuels and other commodities. Moreover, China s FDI inflows to LICs have increased more than ten-fold since 2003, mainly in natural resources and infrastructure (see chart 2). (2) Commodity demand China is a large consumer of a wide range of commodities with a sharp increase in its global market share since It plays an especially dominant role in the base metal and iron ore markets, and to a much lesser extent in the global food and energy markets, although China s share of world imports has been rising there also (see chart 3). Empirical analysis suggests that a 3% increase in industrial production (IP) growth in China would lead to a 6% increase in both oil and copper prices, while the impact on other commodities such as zinc and aluminium is small. Given these findings, it is also understandable why the Middle East and Africa (i.e. the oil and base metal exporting countries) have seen the largest positive effects on their trade balance as a percentage of GDP, while other commodity importing countries are worse off when the same shock applies to Chinese industrial production (see chart 4). The Mainland s increasing emphasis on domestic consumption will only accelerate its commodity import demand, supporting global commodity prices as a result. However, its growing role in commodity trade also implies that an adverse shock originating from China could have a much larger and broader impact on commodity markets than in the past. This is exactly why many commodity investors are so concerned about a hard landing in China. However on the flipside, commodity importing economies would benefit if global commodity prices were to fall with a slowdown in Chinese growth (as well as US and European growth) as this would ease inflationary pressures, giving room for central banks to cut interest rates. That said, China s overall impact on commodity markets, while significant, remains smaller than that of the US given a relatively smaller share of world consumption for some key commodities, such as crude oil. Chart 3: China s share of global commodity imports Chart 4: A 3% increase in China s industrial production growth raises commodity exporting economies trade balance Source: IMF Source: Shaun Roache /5

3 (3) RMB appreciation Economists Papa N Diaye and Nathan Porter s analysis find that a 20% appreciation of the RMB real effective exchange rate would lower China s GDP by 8.8% in 5 years, while boosting the output for the rest of the world, in particularly Emerging Asia (see chart 5). With the appreciation help shifting China s GDP composition towards domestic demand, this would mean an increase in China s import demand, and therefore improvement in the current account balances for most economies in the world. However, RMB appreciation at the same time would reduce China s exports, leading to a reduction in China s current account surplus by around 2.9% of GDP in 5 years (see chart 6). Chart 5: Impact of RMB appreciation on other regions GDP (%) Chart 6: Impact of RMB appreciation on other regions current account (in % of GDP) Source: Papa N Diaye & Nathan Porter 2011 Note: I-O is Input-Output analysis and GVAR is Global Vector Autoregression analysis. Both models quantify the short-run effects. GIMR is Global Integrated Monetary and Fiscal simulation model which quantifies the cumulative effects at peak over 5 years Chart 7 shows that the competitiveness of other countries in the US market improved (i.e. less loss in their market share in the US) following the 21% appreciation of the RMB against the US dollar from 2005 to Therefore, it can be concluded that the undervalued RMB did hurt the competitiveness of some countries in the preceding period. US officials often argue that the undervaluation of the RMB hurts the US economy. Nevertheless, a pie chart from Federal Reserve Bank of San Francisco (Chart 8) tells us that goods and services that are made in China just accounted for 2.7% of the total US personal consumption expenditure in Moreover, a 20% RMB appreciation would only improve US GDP by 0.07% in 5 years as shown in Chart 5, not as large as other regions. Chart 7: RMB appreciation improves other countries market share in the US Chart 8: US is not as dependent on Chinese imports as we have thought Geographical breakdown of US personal consumption expenditure in 2010 (%) Source: Roberto Benelli & Kai Guo 2011 Source: Federal Reserve Bank of San Francisco 3/5

4 (4) Macro rebalancing process China s top government officials keep reiterating their intention to rebalance China s economic growth more towards private domestic consumption. Charts 9 & 10 are the results of the empirical test that investigates the impact of combining rebalancing policies together with a real appreciation in RMB on both GDP and current account balance using the same methodology by Papa N Diaye and Nathan Porter. This analysis assumes a comprehensive rebalancing scenario through (i) structural reforms to raise productivity in the services sector, accompanied by a shift in households preferences toward non-tradable goods, (ii) fiscal reforms to reduce individual uncertainties and precautionary saving, (iii) financial sector reforms to liberalise interest rates and further develop the domestic capital market, and (iv) a gradual appreciation of the RMB by 20% over 5 years. By taking advantage of the stronger demand from China coupled with a more competitive local currency of the trading partners, the improvement in GDP, in particular in Emerging Asia, in the medium term (i.e 5 years) would be much larger than the effects of currency adjustment only as shown in Charts 5 & 6. China also would see a strong positive impact on GDP compared to a negative impact in the exchange rate alone scenario. The positive impact on the current account balance for the US, Europe and commodity exporting countries would also be more than double the impact of real RMB appreciation alone, while the current account surplus for China and Emerging Asia would become narrower. To summarise, all this indicates that rebalancing through a comprehensive package of rebalancing macro polices would be much more beneficial to the world countries and less costly to China compared to the case with the exchange rate adjustment alone. Chart 9: Impact of RMB appreciation and rebalancing on other regions GDP (%) Chart 10: Impact of RMB appreciation and rebalancing on other regions current account (in % of GDP) Source: Papa N Diaye & Nathan Porter 2011 Note: I-O is Input-Output analysis and GVAR is Global Vector Autoregression analysis. Both models quantify the short-run effects. GIMR is Global Integrated Monetary and Fiscal simulation model which quantifies the cumulative effects at peak over 5 years (5) Forex reserve diversification Economist Roberto Benelli analyses the potential impact of a shift of USD 100 billion in China s forex reserve portfolio (equivalent to about ¼ of annual reserve accumulation) away from US Treasuries towards Emerging Market Sovereign bonds on global bond yields. His simulation results show that US long-term yields would rise by 12bps given the increase in market supply of US debt and yields on UK, EU and Japan debt would also increase, while EM bond yields could fall by 48bps (see chart 11). 4/5

5 Chart 11: Impact of China s forex reserve reallocation on global bond yields Chart 12: Peak impulse response in partners to a 1% GDP shock Source: Roberto Benelli 2011 Note: Other AMs Other Advanced Markets Source: IMF US still matters the most at the current stage It is true that China is getting more and more important to the world. However, its spillover effects are still not as comparable as to the impacts of the US to the global economy. Hence, the conventional phrase when the US economy sneezes, the rest of the world catches a cold is still valid at the current global development stage. That is also why investors are always wary about the US entering into a double-dip recession. This is supported by the IMF s consolidated spillover report which explores the external effects of policies in 5 systemic economies - China, Eurozone, Japan, UK and the US. The results show that only the US could affect all the other 4 partners more profoundly when the country has a 1% GDP shock (see chart 12). It appears neither because of its size (as it is about the same as Eurozone) nor its trade (as it is about the same as China). It is rather its financial channel that really matters to the whole world as the US dollar is still the most important global reserve currency and the US has a huge financial sector that is heavily interconnected with most, if not all, the economies in the universe. Having said that, China is likely to generate more financial spillover effects beyond its forex reserve diversification in the foreseeable future given eventual RMB internationalisation and full opening of its capital account. As a result, China s spillover effects to the world would become so much bigger by then that no country will be able to ignore. References 1. People s Republic of China Spillover Report Article IV Consultation & Selected Issues by Ranjit Teja, Lorenzo Giorgianni, Rishi Goyal, Roberto Benelli, Nathan Porter, Kai Guo, Jarkko Turunen, Papa N Diaye & Shaun Roach. IMF, June Consolidated Spillover Report Implications from the Analysis of the Systemic-5 by Ranjit Teja & Rishi Goyal, with input from Tamim Bayoumi, David Marston, Aasim Husain & Martin Muhleisen. IMF, July /5