Energy shock, China shock and the global economy

It's Thursday, 1st of October and this is your capital economics week, the briefing. My name is Neil Shearing, Group Chief Economist and I'm delighted to be joined by Jenny McEwan, our Chief Global Economist and Mark Williams, our Chief Asia Economist to pick through what's been another busy week in macro and markets. Hi, Jenny, hi, Mark. Hey, Neil. Hi, Neil. Right. It's a tale of shocks this week. We've had an energy shock continuing and we've just been publishing the series. We've worked on the China Shock 2.0, so I thought we'd get into both of those things on this podcast. Let's start with the energy shock, Jenny, because you've just published our latest global economics outlook. This is the quality flagship publication outlining all of our forecasts for the next two or three years and the title of it is "Wethering the Storm", so "Wethering this particular shock in the form of energy". Why is that, do you think? And is the global economy been so resilient in the face of what has been quite a significant energy shock? It has been quite impressive that global economy is still growing at around about it. It is trend pace just under 3% per year and I think if you told us quite how high energy prices would be, how persistently this energy price shop would be, most people would have assumed that the impact on the global economy would have been worse than it has been. I think a few different factors have support the global economy. One is that many governments have shielded their economies from the worst of higher energy prices using either price controls or subsidies, that's been the case particularly in many parts of Asia. And then also households have been able to dip into their savings to continue to spend even as their real incomes have been hit by surging energy costs that applied in particular across advanced economies in Europe and also in the US. And then coupled with that, of course, we've had continued tailwind in the form of AI and the impact of that having not just on investment in the US but the support that is offering to exports particularly across Asia. Yes, a lot of the households are reducing savings in the year-up terms of trade shock not being quite as big as we expected or perhaps not as big as was the case in 2022. Again, these things are not happening in isolation, the point we make all the time is not happening in isolation. And we have this AI investment boom taking place particularly in the US. But Mark, let me just turn to you and bring you in here because I'll just try to fit into to all of this. It's obviously a big net energy importer and actually some of the data from China have been soft, haven't they, over the past few months. So is that the case that the energy shocks hitting there was something else going on. Yeah, you're right that it has been weak but I don't really think it is the energy shock. I mean, it did look when the Rand War started, it looked like a lot of Asian economies could be some of the worst affected outside the Gulf itself, given that 80 to 90% of both petroleum and natural gas that left the Gulf kind of turned left and headed to Asia. As it's turned out though, a lot of these economies had pretty decent stockpiles, certainly the case in China, they've been able to draw on and there's been other measures to reduce to mind it. And it should be remembered that in China's case, it's not that oil intensive economy uses a lot of energy but it's a lot of those coal generated. So the direct pass through to China's economy from higher energy prices has perhaps been less severe than people had feared. However, the economy, as you say, the last few months of data have been pretty weak. That's partly to do with weather, so there's been typhoons that have disrupted construction activity, but it's also, if we look at the data that we had for August, retail sales in real terms were actually negative, growth was negative, so sales were lower in August than they were a year before, which is pretty striking, you know, for an emerging economy that many, you know, think should be one of the fastest growing economies in the world. So the consumer side of China's economy is not doing well at all. However, at the same time, the export numbers are still incredibly strong. Because exports are up about 25% year on year, that's in dollar terms. So yeah, it's an economy that depending on where you look at it, you can see a lot of weakness, certainly on the consumer side of the economy, or you can see a lot of strength on the export side. Yeah, all right. I want to come back to that export point because it's critical to the China shop 2.0 work, but just on the domestic economy, we had an announcement, didn't we earlier this week, about more stimulus measures, is that likely to produce much in terms of an economic upturn over the coming months and quarters? Yeah. So the state council was unusually downbeat here. There was a statement out on Monday where they said that the economy was facing problems, and that word problems doesn't appear very often in state council statements. Last time it appeared was towards the end of 2024, it was followed by some stimulus measures. So a lot of people were kind of thinking, you know, maybe this is another signal. And we did get some announcements, actually, just after earlier this week on Tuesday, we got some announcements from the people's bank of certain reductions in rates and some of its lending facilities, and there's a new subsidy scheme for mortgages. You get one percentage point off your mortgage interest rate. Now, if you meet certain criteria, which in practice are quite tight, these criteria has to be quite a small home low value, and you have to be a first time buyer. But there is certainly a pivot there. So the last few months of data have not been great, and now policymakers are signaling that they are wanting to be a bit more proactive in responding to it. So what we've seen so far in terms of that response, I don't think it's going to make a massive difference to the economy. These are really small measures. But we might see more follow-up, and particularly on the fiscal side, there is space in the already published budget for this year for local governments in particular to do more spending over the next few months. So that's probably where we'll see a bit of a push to get activity moving again. But don't get your hopes up too high, we're still thinking that China's great this year will be in the region of 3% or so. So it's still much lower than the official figures are likely to show. That does, though, doesn't it, Jenny, contrast with the development markets, at least in terms of the policy support, I mean. So we have China's central bank potentially loosening some policies, but central banks in the advanced world, the advanced economies tightening policy. And again, that was a theme of the GEO, the global economic outlook. But in our judgment, bond markets have probably gone a bit too far, in terms of pricing in monetary tightening over the coming months now. We've kind of gone from a position where at the start of the year, we're a bit more hawkish than the markets on interest rates, and now that the markets have overtaken us, we think they've perhaps gone a bit too far. Explain why that's the case. Yeah, that is the case. I think there's a bit of a tendency to look at this energy shock through the lens of 2022, when, of course, central banks were a bit behind the curve. They ended up having to tighten policy very aggressively, as inflation took off and they couldn't get it back and trying to get it back under control. But actually, the way we see things is that this is a very different situation now to that that we were in in 2022, during the last major energy shock for a few reasons. One is that you mentioned that monetary policy is already being tightened, but it's also the case that fiscal policy isn't being loosened to anywhere near the same extent that it was back in 2022, when there were still several COVID measures in place, keeping deficits very high and degrading. It's also the case that interest rates are starting for a much higher starting point now. So that means that you've not got so much policy accommodation that needs to be removed. And perhaps most importantly, labour markets are nowhere near as tight as they were back then. So we think there is a much lower risk of second round effects taking hold where increases in energy prices spark demands for higher wages, which then push prices even higher and so on. So a very different position. We think that core inflation while it will rise somewhat in the near term due to indirect effects of higher energy prices on things like transport, we think that it will ease back off before long and that central bank will be able to stop their tightening cycles fairly quickly. We expect in the US, for example, just two more rate hikes or just one more in the Eurozone. Right. So from energy shocks to China's shock, Mark, you mentioned earlier that one of the parts of China's economy that's doing reasonably well is the manufacturing sector, the export sector. And that ties into a big theme, a big piece of work, series of work we've been publishing over the past couple of weeks and we'll continue to publish on over the coming weeks about China's shock 2.0. So this is the idea that the world's facing a second China shock, another surge in Chinese exports similar to the first China shock in the mid-2000s in that it's a big surge in exports from China that the rest of the world's absorbing, but different to scale other shocks bigger. It's affecting goods further up the value chain of production and clearly there's a geopolitical angle. And I mentioned to this China shock that wasn't present necessarily in the mid-2000s. So just striking, you put out a piece at the start of this series looking at the kind of origins, the roots of this second China shock. I think one of the key points you make is that it's not something that's just kind of happened back and it's kind of by design almost, in terms of it's rooted in deliberate policy decisions by Beijing. Just explain what you mean by that and what it means in terms of the duration of this China shock and why it's so structural. Well China has an unusually unbalanced economy in the sense that it invests a far higher share of its income than other economies do and it consumes a lower share of its income. And it's been doing that for a very long time. So I've been in this job for quite a while. I remember back in 2007 one job out the prime minister said that China's economy was unbalanced, uncoordinated and unsustainable and he was referring to the fact that at that point China was investing 40% of its income and here we are 19 years later and China is still investing 40% of its income. Now 10 years ago a big chunk of that investment was going into real estate and we know that that rather that was wasted it was creating ghost cities empty apartments and so on so sort of over capacity in the form of empty buildings. Once China's property correction started in late 2020 that investment didn't just stop it was instead kind of pivoted into manufacturing so China still is investing this incredibly high share of its income and that inevitably leads to over capacity domestically and there are policy measures taken in China to make sure that companies still get support to stay afloat even though they might be losing money and an official measure close to a third of firms in China are currently losing money but they can continue in business because they get support from the banks from the government. And you might I was going to why would they extend that support? It's partly at the local level because local governments are concerned about domestic employment, domestic social stability. There was a concern about the domestic tax take and loss making firms still pay taxes so it's still good in that sense for them but from the central government's perspective it also helps with some of their big strategic goals and if we look at the five-year plan that was published in March the first strategic goal there is for China to achieve leadership in high-end technology and the second one is to achieve greater self-sufficiency. So having a really big industrial sector even if a lot of the firms are really struggling in that sector it helps on both of those goals. So from thinking about it in terms of the imbalances within China's economy these exports are really a sign of an economy that's under quite a lot of strain that there's not enough domestic demand to consume everything that is produced domestically and so the only way out is to export it but from the perspective of China's leadership actually this is all all to the good because it shows that China is dominating in advanced technology and it is becoming less reliant on imports from the rest of the world and making the rest of the world more reliant on imports from China. So although from our viewpoint of this analysis this is actually probably weakening China's economy overall from the perspective of China's leadership it's something that they actually like to see and therefore the policies that are sustaining it and keeping these companies going are going to continue at least for the foreseeable future. Yes and all of that has costs or some costs for the rest of the world. I want to get into that Jenny but we shouldn't overlook the benefits of this either. I mean we're all consuming vast amounts of cheap goods produced in China that has benefits for consumers too. That's not it. So before we get into the kind of negative side of this downside of this for the rest of the world want to start with it because something more optimistic take one of the positives for global consumers from this. Yeah well it's certainly the case that China's rise and it's growing export market share has helped to reduce prices of consumer goods around the world especially in the advanced economies. That has particularly been the case in the goods where competition from China is strongest. So things like toys, consumer electronics, furniture have seen some really significant declines in prices relative to the sort of pre-1990s trend. However these types of goods are not a very very high share of consumption imports from China account for something like 2% of total consumption in the advanced economies on average. So for that reason even though the drag has been quite significant the impact on headline inflation rates hasn't really been all that apparent most estimates suggest that China's rise has attracted about a 0.2 percentage points from annual inflation rates in the advanced economies. But nonetheless there have been really significant impacts on certain types of goods and consumers have felt the benefits of being able to buy a lot more goods even if the bulk of their spending on on services has been unaffected. Other clear beneficiaries have been the economies that are closely linked to China's supply chains and the economies that have benefited from China plus one such strategies from importers where they've tried to import not solely from China but from an alternative low-cost supplier as well. Most notably the economies of Southeast Asia the Sian economies have really benefited and seen the global export market shares rise alongside China's as they've benefited from the reorganization of global supply chains. Okay so some benefits for global consumers in the form of cheaper goods but we probably would all know over egg that pudding maybe 0.10.2% off of annual CPI inflation perhaps and then some benefits to for economies in Southeast Asia. Well one of the costs who are the kind of losers in all of this because I think if you cast your mind back to the first China shock in the mid-2000s I mean I was at the UK Treasury at the time the idea then was that this is something that we should all welcome. We should all recognise the production the means production according to comparative advantage and China had a comparative advantage in a lot of this low end manufacturing production and the rest of the world would benefit through the gains from trade so we should just let it happen but then in the mid-2010s there was a series of very influential papers from US academics saying that actually imposed quite significant costs and those costs were concentrated in particular regional areas in the US and so I think that's perhaps altered the lens through which we're viewing the second China shock now I think we're a bit more aware of the potential consequences in cost so where are those likely to be felt? Where are those being felt? That's absolutely right there are a few different areas where you can see that the strains related to China shock too if we look purely at how the counterpart to China's large and growing manufacture goods surplus that's very much been the US that has been absorbing a growing volume of imports to as China's trade surplus has been increasing so that's created in balances within the US economy in particular it's given rise to growing public sector deficits, fiscal deficits which have created vulnerabilities in the US economy but another way to think about this is to look at which economies have lost export market share as China's has risen and that applies to the US to some extent too but more importantly to other advanced economy manufacturers particularly Germany and Japan who have really lost out as China has succeeded a key reason for their loss of market share particularly in the eurozone's case is that China is increasingly competing directly with manufacturers in advanced economies which means that they've had a convergence in export structures and given the significant cost advantage that Chinese producers have it's been incredibly difficult for producers in the likes of Germany to compete directly in areas such as autos or in higher tech manufactured goods where they had traditionally been stronger. Okay so cost this time in Europe and I think another big contrast with the first China shock as you say Germany's been hit in the second China shock and they were potentially a beneficiary that in the first China shock through China's big capsule intensive growth back then Mark just to wrap this up give us your best sense of how all this plays out over the coming years perhaps over the the next say one to two years and then what's the kind of final end game so certainly over the next one to two years as I was saying we think that the policies that China's leadership is pursuing are imposing costs on its economy but the view from Beijing is that these policies are working and so there's no prospect of them changing in the next one to years there will be more tensions with trading partners particularly with European governments undoubtedly but the response from Chinese government to complaints that they're being flooded with Chinese goods while they're struggling to sell anything to Chinese consumers is simply that European firms need to get better at making this stuff that Chinese consumers want to buy they don't really believe in the view that there is some fundamental weakness in China's economy but that is holding back their willingness to buy imports so no prospect I think of a significant change in the next two or three years but if you go beyond that I mean if we're right on this and these costs they will continue to mount over time China's growth will continue to slow then at some point it becomes untenable to believe that these industrial policies are the sort of the engine that is powering China's emergence as the global economic superpower at some point it will become clear that actually that catch up that people is sort of almost taken for granted is faltering so there might be some rethink at some point not in the next two or three years but in the 2030s and at that point something else might also have happened which is that one of the big motivations for holding on to a large industrial sector is because China's leadership for pretty good reason has wanted to become more self-sufficient is be less dependent on inputs from the West because obviously for geopolitical reasons they're concerned that they might be cut off now there's still work to do there there's still very dependent on developed economies the West the common is for advanced ships for example but it is plausible that by the early 2030s a lot of those vulnerabilities that Chinese leadership sees in its dependence on the West will have been filled so in other words you get to a point where a combination of concern about the growth trajectory and greater confidence in China strategic position could lead to a change of policy in Beijing, but that won't be happening before 2030. That was Mark Williams and Jenny McEwan on energy shocks, China shocks and the global economy. Lots more to come on our China shock series. I'll link to some of the key pieces in the show notes. Lots more, as I say, to come on things like global imbalances, what the China shock might mean for the green tech revolution, and also how this is playing through financial markets. You can find all of that on our website www.capsuleconomics.com. You can also find the global economic outlook that Jenny was talking about there too. For now, though, thanks very much for listening, and we'll speak to you again next week. Goodbye.