China’s economic slowdown is a big deal

Contrary to what its critics might think, the Federal Reserve is right to be paying close attention to Chinese economic developments. Not only is China now the world’s second-largest economy and a major engine of global economic growth, but China’s economic slowdown is also having a major impact on the formerly very rapidly growing emerging market economies as well as on global financial markets.

{mosads}Those who criticize the Fed for delaying a start to the normalization of U.S. interest rates due to signs of a Chinese economic slowdown dismiss China as having only a limited impact on the U.S. economy. They argue that while China might account for over 20 percent of overall U.S. exports, this amounts to little more than 2 percent of U.S. gross domestic product (GDP). As such, even if China’s economic growth were a full 5 percentage points below what might otherwise have been the case, all that would do is shave around 0.1 percent off of U.S. economic growth.

In dismissing China’s importance for the U.S. economy, the Fed’s critics overlook the adverse impact that China is already having on the other major emerging market economies, which up until now have been a major contributor to global economic growth. This impact is being exerted by China through a precipitous fall in international commodity prices to levels last seen in the immediate aftermath of the Great Economic Recession of 2008-2009. As a result of this commodity price collapse, together with an abrupt reversal in capital flows to the emerging market economies, major countries like Brazil, Indonesia, Russia, South Africa and Turkey are all now facing acute economic strain.

An even more important transmission channel being overlooked by the Fed’s critics is the impact of the Chinese slowdown on global financial markets in general and on global currency markets in particular. Not only have Chinese economic developments contributed to a virtual collapse in the currencies of the major commodity-exporting countries to levels not seen in more than a decade; those developments are now raising the very real prospect that both the Bank of Japan and the European Central Bank will step up their quantitative easing programs in an effort to boost their respective economies through a further cheapening in their currencies. They have also contributed to the wiping out of more than $5 trillion from global equity valuations.

Over the past year, the U.S. dollar has already appreciated by close to 20 percent. According to International Monetary Fund (IMF) estimates, in time, such an appreciation could shave off around 1 percent from U.S. economic growth as well as 1 percent from U.S. inflation. This would make one think that the Federal Reserve, whose dual mandate is to promote employment and to maintain price stability, is right to be concerned about the possibility that any further slowing in Chinese economic growth might lead to a further appreciation of the U.S. dollar. Any such further appreciation could make it difficult for the Fed to deliver on its dual mandate and could again raise the specter of deflation.

In setting monetary policy, the Federal Reserve necessarily has to be forward-looking. This is especially the case considering that monetary policy operates with long lags. Given China’s increased relative importance and its potential to exert a deflationary shock to the global economy, the Fed would have been remiss to turn a blind eye to increased signs that China’s outsized credit bubble of the past few years might now finally be bursting. For that reason, one has to applaud the Fed’s decision to ignore its critics and to delay the much anticipated start to the process of normalizing U.S. interest rates.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.