The Hypothetical Scenario
1. Some shock occurs in the Chinese economy starting in late 2010 that reduces 2011 GDP growth to 4.7%. The underlying cause could be anything from property bubble bust to Chinese banking crisis.
2. The slowdown in China would only be temporary as GDP growth rebounds to 7.2% in 2012 and 9.8% in 2013.
3. Chinese property prices fall 15% from recent peak in 2010 and recover in late 2012.
4. Property price declines cause major problems for Chinese banks, requiring the central government to recapitalize the banking system.
5. Shanghai stock market falls 50% during first half of 2011.
The Impact of a Chinese Slowdown
In this scenario, world GDP growth in 2011 would decline from 0.5% to 2.7%, with emerging Asian countries the most hard hit. Fitch predicted that growth in emerging Asia would slow to 4.7% down from the base estimate of 7.3%. The US would fare a little better with a reduction of 0.4% along with the EU region which would see growth lowered by 0.2%. Latin America GDP growth would be slowed by 0.3% to 3.9%.
While world GDP growth only moderates under the scenario, commodities will be vulnerable to large price declines. Fitch estimates that commodities could fall 20% across the board with industrial commodities being hit the hardest.
While almost every aspect of the world economy would be affected by a slowdown in China, there are a few beneficiaries. Industries like retail, consumer products, overseas power generation, and certain companies in the steel industry which have no upstream integration do well. Retail and consumer products benefit because of lower wholesale prices due to reduced labour and manufacturing costs in China (the US consumers will love this). Overseas power generators will do well as lower fuel costs increase profit margins, but they could be impacted by slightly lower demand. Fitch also seems to think certain steel companies will benefit from lower iron ore and coaking coal prices help to protect margins in the face of lower demand (I am not sure Fitch is correct on this one).
Global multinationals that have manufacturing subsidiaries in China will be negatively impacted. Sectors most impacted will be in the automotive, heavy machinery, chemicals and commodities sectors. Fitch estimates that large US industrial companies derive 10-20% of their revenue from Asia. Determining how much exposure to China is difficult because most companies do not break down revenues by country. But Fitch thinks the industries most impacted would include global automotive sector would be hit the hardest, putting pressure on companies such as Volkswagen, GM, Toyota, and Honda.
Another sector impacted by a Chinese slowdown is the US restaurant chain sector, which is heavily dependent on Chinese operations for growth. For example, Yum Brands relies on its Chinese operations for 34% of total revenues and 35% of the group’s operating profits in 2009.
The slowdown in China would also impact global markets as the risk trade is abandoned by the major trading desks and hedge funds. Fitch estimates that Asian stock markets would fall 25% in sympathy with the sell-off in China. US and European markets would also fall but not by as much as emerging markets. The large decline in equities would precipitate a widening of emerging market sovereign credit spreads, causing them to widen by 100 bps. Asian banks would also be negatively impacted, especially in Hong Kong, Taiwan, Japan, Korea and Australia due to the deterioration in asset quality.
For purposes of this simulation, Fitch assumes contagion risk is relatively low and does not consider an Asian Financial Crisis scenario.
Countries at Most Risk to a Chinese Slowdown
The countries that are at most risk to a slowdown of China are heavily dependent on commodity exports. Fitch took a look at which countries rely most on commodities as a percentage of their current account balance. These countries would be impacted the most.
I have a few problems with Fitch's assumptions, especially regarding the temporary slowdown for China in 2011, but then a swift recovery into 2012-2013. Do you really think the Chinese economy could recover so quickly from a banking crisis that required the government to recapitalize the entire banking system? Somehow, I do not think it is that easy. Historical evidence says countries recover much more slowly from banking/financial crises (5-10 years) than general business led recessions.
Furthermore, the assumption that commodity prices only decline 20% seems too optimistic in my view. If the Chinese economy suffered a banking crisis and the country were subjected to a prolonged period of low growth, commodities would fall much more as the whole reason for owning commodities is Chinese growth.
Overall, I was surprised that Fitch would commission this report because rating agencies are not known for their keen sense of foresight. They are notorious for constantly downplaying major risks and favoring positive outcomes. Maybe they have learned something from the whole financial crisis!
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