Similar to August 2015, the negative headlines on China’s economy and stock market caused broad-based selling in global equity markets over the past few weeks. While a slowdown in China is important to the global economy, the hard facts do not support the degree of panic selling in developed market equities. According to economist Paul Krugman:
“China buys more than $2 trillion worth of goods and services from the rest of the world each year. But it’s a big world, with a total gross domestic product excluding China of more than $60 trillion. Even a drastic fall in Chinese imports would be only a modest hit to world spending.”
Thus, the economic impact of China buying fewer goods from the rest of the world is not likely to cause a global recession. However, it will continue to suppress commodity prices which is not good news for Canada’s key commodity-producing provinces such as Alberta and Saskatchewan.
The more important question is whether China’s economic slowdown and pile of bad debt will result in financial contagion globally similar to the 2007-2008 US housing crisis’ impact on global financial markets. As an aside, we believe that the size of the US financial crisis was likely the type of event we only see once in our lifetime, and it has created an entire generation of investors that are constantly looking for the next 2008-style bear market.
Our view is that financial contagion stemming from China has a low probability of spreading globally, as the answer likely lies in the lack of openness and transparency in China’s capital account. As highlighted in Figure 1, the Chinn-Ito Index is a statistical measure of a country’s degree of capital account openness where a score of +2.39 (most G8 countries) represents a fully open capital account system and a score of -1.89 represents a closed and opaque capital account system.
China and India are not ranked very favourably on its degree of capital account openness, thereby demonstrating the continued opaque nature of China’s financial system. Naturally, countries with more open capital accounts have a higher probability of spreading financial contagion globally since their capital markets are highly interconnected and correlated.
The opposite is true of China. While China is moving towards more capital account openness, particularly with the renminbi’s October 2016 inclusion as a reserve currency, it is far from transparent and open. As a result, its financial markets are still relatively isolated, and have a low probability of spreading financial contagion globally.
References: Chinn, Menzie D. and Hiro Ito (2006). ”What Matters for Financial Development? Capital Controls, Institutions, and Interactions,” Journal of Development Economics, Volume 81, Issue 1, Pages 163-192 (October).