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The Sunday Paper – Global Spillovers of a China Hard Landing

What makes the International Finance Discussion Paper highlighted today from the Board of Governors of the Federal Reserve System so useful is not just its scholarly conclusions, but also its commonsense observation that in reality their work may provide only conservative estimates of the magnitude of a global shock resulting from a China hard landing.

The main conclusions are as follows. In the event of a China hard landing:

  1. The U.S. dollar would appreciate
  2. Long-term U.S. dollar yields would fall
  3. Global Emerging Market (EM) bond spreads would widen
  4. World trade would fall
  5. Oil and all metals prices would fall, in some cases sharply

The effects would be disproportionately felt, in the following order:

  1. EMs would be hit with a shock equal to 0.75x of the China shock
  2. Less directly connected EMs would feel 0.5x of the China shock
  3. Advanced economies would feel hits of up to 0.33x the China shock
  4. America would be the least affected of the world’s major economies

America would be less affected because:

  1. It’s economy is more ‘closed’ than many others
  2. There’s very little direct financial linkage to China
  3. It has more capacity to alleviate shocks with easier monetary policy

So that’s the in theory story.

We’re lucky enough to have a recent shock though to see what happens, in fact, when China wobbles. In the summer of 2015 capital outflows from China prompted the authorities to surprise-devalue the yuan by 2% in August and then, as we all know, financial markets went into a tailspin.

The 2015-16 experience prompts the researchers to conclude that an in-theory lack of effect on the U.S. could turn into an in-fact hit there of as much as a 0.33x of the original China shock.

The bottom line here is the bigger China gets, the bigger the shocks any wobbles there are going to cause for the rest of us.

The practical takeaway is also to be reminded when this happens [It will one day. It’d be naive to imagine otherwise] don’t let ‘experts’ convince you at that time knock-on effects will be modest or contained.

You can read the paper in full by following this link China Hard Landing.

Happy Sunday.

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