US resilience to China's stumbling recovery questioned in Fed risk study

By Christopher Condon

China’s stumbling recovery this year has produced a string of reassurances that the impact on the US of even a sharp downturn in the world’s second-largest economy will prove limited.
 

Just last month, economists at Wells Fargo estimated that if China’s total output dropped by a cumulative 12.5% over three years, US growth would dip 0.2 percentage point in 2025. And Nobel laureate economist Paul Krugman recently concluded that, as to whether a debacle in China similar to the US crisis of 2008-09 would would “pretty clearly” not result in major global spillovers.

A little-noticed study by the Federal Reserve published in 2019 offers a more cautionary perspective. Eight Fed economists at the time examined a scenario in which China’s growth fell 4 percentage points short of projections in a year. They predicted a global flight to safety by investors would send the dollar surging about 7% and cause both long-term Treasury yields and equities to tumble. US growth could in time drop more than 1 percentage point.

 

Anna Wong, one of the paper’s authors and now chief US economist at Bloomberg Economics, says those projections would be just as valid today should China’s growth — currently expected to reach 5.1% this year and 4.5% in 2024 — fall short to the same degree.

Like other economists, Wong and her co-authors noted that trade with China represents only a modest proportion of American gross domestic product. But, given China’s deepened integration into the broader global economy, they concluded that a significant downturn for the Asian giant would cause real damage to the US — largely through the vector of financial markets.

“The most important channel for China spillovers is not through direct trade but rather a risk-sentiment channel,” Wong said this week. “Fears of a China hard landing, if serious, raise financial volatility and drive the dollar up, which could turn financial assets into a risk-off mode, which in turn tightens global credit conditions.”

The 2019 paper didn’t predict the likelihood of a downturn that triggered a risk-off reaction among investors, only the consequences should such a thing occur.

Emerging-market countries that rely on China as an export market would feel the most pain from a drop in demand for their goods and commodities, the study showed.

Today, such a situation would add to strains at a time when the level of debt among developing nations is already elevated. After the Covid pandemic and a spike in food and energy costs triggered by Russia’s invasion of Ukraine, distress among low-income countries is at its worst since the early 1980s, Harvard University economist Carmen Reinhart has calculated.

Evidence of the potential for China woes to reverberate through global financial markets stems from an episode that began in August 2015. Capital flight from China spurred a sudden depreciation of the yuan and precipitous drops for Chinese equities. The turmoil proved contagious, sending the US S&P 500 tumbling more than 11% over the space of little more than a week.

Fed policymakers abandoned a plan to raise interest rates at the time, putting it off until the end of 2015. While the US central bank was expected to raise rates another four times the following year, continuing concerns about China contributed to an extended pause, with the next increase only coming in December 2016.

Janet Yellen, who chaired the Fed back then and is now Treasury secretary, said last month that China’s current slowdown a “risk factor” for the US. 

A major China shock today might have mitigating factors. Any resultant slide in global commodity prices would help ease US inflation, which remains well above its 2% target. And the Fed has plenty of scope to lower interest rates if needed, with its benchmark now exceeding 5%. Back in August 2015, the benchmark was near zero.

In the end, the worst worries about China’s economy in the 2015-16 episode proved unfounded, as it continued to clock around 7% expansion rates — leaving unanswered the question of what would happen in the case of an actual 4 percentage-point disappointment to growth.

(Updates with context on Yellen’s perspective, in third-to-last paragraph.)