China's Impact on its Neighbours and What Lies Ahead for Asia

The IMF recently released its latest prognostication for Asia's economy and things are not particularly looking great.  The world's economic engine is looking like it might be starting to show evidence of "Euro Influenza" as the impact of Eurozone debt and banking issues spill over into Asia.  Here's a brief summary of what the IMF predicts in its Regional Economic Outlook for Asia and the Pacific.  I'll also post a bit of information from the Outlook showing how big China's impact is on the world's economy and how a slowdown there would impact its neighbours and the rest of the world.

The IMF opens by noting that the world economic recovery is much more sluggish than it appeared to be back in the spring of 2011, particularly because of the eruption of Eurozone financial turbulence.  Economic growth from advanced economies is weak and is unlikely to improve; this will most likely lead to decreasing external demand for goods produced in the Asia-Pacific region.  Despite the drop in external demand, internal demand is expected to remain robust which will lead to both an increase in both credit and inflation in the area.  Internal demand has been resilient largely because of increased employment and gains in real wages, the complete opposite to what is being experienced in Europe and the United States.  In the Asia-Pacific, the conflict between a potential economic slowdown because of dropping exports and an increase in inflation as a result of high domestic demand means that Asian central bankers are walking a very fine line between over-tightening and not tightening enough.  Here is a look at the year-over-year change in inflation rates since January 2011 for selected Asian countries:

On a year-over-year basis, inflation increased from 4.6 percent in January to 5.5 percent throughout the entire region due to both increases in commodity prices and the pressures of increased demand for goods.  Inflation remains above central bank targets in Vietnam, Korea, Hong Kong and China.  Contrary to this, Japan is still mired in deflation with negative core inflation when food and fuel are excluded.  Here's a rather cool graph showing which countries are within their inflation targets by month with the red months showing that inflationary pressures are above target and rising and which are not:

The IMF has changed its growth forecast for the region since its last report in April.  Growth for 2011 is expected to be 6.5 percent (down 0.5 percent from their previous prognostication) and for 2012 is expected to be 6.75 percent (down 0.25 percent).  Growth levels of this magnitude would be positively amazing for the world's advanced economies where many nations are on the cusp of seeing economic contraction.  The drop in economic growth in the Asia-Pacific region is almost exclusively related to a drop in exports to the world's advanced economies where the IMF's economic forecast shows declining growth levels.  Here is a chart showing the IMF's latest Asian growth projections by country:

Taking a closer look at the economic giants of the area we note that China is still expecting growth of 9.0 percent in 2012, Taiwan is expecting 5.0 percent , Korea is expecting 4.4 percent and India is expecting 7.5 percent growth.  On the downside, Japan is expecting growth of only 2.3 percent following a contraction of 0.5 percent this year and Australia is expecting growth of only 3.3 percent following 1.8 percent growth this year.  With this economic dichotomy, if Asia's central banks raise interest rates too much, they risk either pushing their weaker local economies into a slowdown or increasing the value of their local currency which will make their exports even more expensive to consuming nations.  Oh what a tangled web!

Despite the very high growth levels in many Asian nations, their stock markets have not been immune from the "Eurozone Influenza" which struck with a vengeance during the summer.  Here is a look at how three of the Asian markets responded to the multi-country debt debacle:

1.) Nikkei 225 Index:

2.) Shanghai Composite Index:

3.) Hang Seng Index:

Stock markets throughout the Asia-Pacific noted declines that paralleled those seen in advanced nations in August and September.  This demonstrates that there is no safe place to hide from the "Eurozone Influenza" and from the after-effects of the United States debt near-default.  You may try to run, but you definitely cannot hide!

Now, let's change gears and take a closer look the impact that China's economy has on the rest of the world and on its neighbours.

Let's start by looking at China's inflation.  This graph shows you how volatile consumer price inflation has been in China (blue line) over the past five years when compared to the rest of Asia (green line):

Inflation in China spills into the surrounding nations (and from there into the rest of the world) with a one percentage point increase in China's inflation that is related to supply and demand shock leading to a 0.25 percent increase in the rest of the Asia-Pacific. Because China is the dominant importer of many of the world's commodities, in particular metals, the impact of their demand on the world's supply and price reaches far.  Here's a graph showing how much of the world's total imports of certain commodities are imported by China noting that the country is not yet impacting the world's food supply and demand equation:

In 2009, China consumed 65 percent of the world's imports of iron ore and 53 percent of the world's soybeans, nearly doubling since 2000.  China has been the world's largest consumer of iron ore since 1992 and produces 47 percent of the world's steel.  In total, China imports 29 percent of the world's total imports of all metals and 13 percent of the world's imports of all raw materials.

Looking even further into the problem of China's growing demand for commodities, the IMF calculates that a one percentage point increase in China's output may raise commodity price inflation by about 5 percent!  Now that's what I call an economic powerhouse!

China's ASEAN neighbours have been big suppliers of exports to China with commodities including iron ore, petroleum and rubber which have replaced exports of information technology.  This increase in commodity exports is expected to continue for the foreseeable future as China ramps up its construction of social housing projects.  Here is a graph showing how much exports to China from its neighbours have grown over the past three years, in some cases doubling in value:

Should China's economy slow down in a meaningful way, the impact on its commodity-rich neighbours would be widespread, leading to a slowdown in their economies.

With this information in mind, it is interesting to see the issues facing the world's new economic powerhouse.  With China reporting its lowest economic expansion since 2009 for the third quarter of this year, a deceleration in their economic growth pattern seems to be in place.  While growth is still a robust 9.1 percent, it is at its weakest level since the second quarter of 2009 when it hit a low of 8.1 percent.  While growth levels of this magnitude are unheard of among OECD nations, the impact of China's economy on the rest of the world cannot be denied, most particularly on its Asian neighbours.  Should China's economy continue to slow, the "Asian Influenza 2011 Variant" could create further nightmares for central bankers and other policy makers throughout the Eurozone and America who are already struggling to keep their economies above water.  Apparently we really do have most of our eggs in a single basket.  Three cheers for globalization!