Published in Business Spectator (Melbourne), 27 August 2015
Just when the Europeans thought they had calmed down the euro crisis with their third bailout package for Greece, they are reminded of how fragile their economy still is. For a change, Europe’s new worries do not originate from the continent itself. Instead, they stem from the fallout of China’s dramatic slowdown.
Stock exchanges worldwide recorded large losses as a result of the Chinese stockmarket crash. European indices were no exception, with Germany’s DAX one of the worst-performing examples.
Having reached an all-time high of 12,390 in April this year, it is now trading around 10,000 points. The French CAC 40 and Italy’s FTSE MIB index also recorded substantial losses in recent days and weeks. However, unlike the DAX, whose 2015 gains have been completely wiped out, the French and Italian indices are still showing a positive annual return.
Part of the European stockmarket crash may have been an ordinary correction of past exaggerations, for which China was the catalyst. We should not forget that the DAX had more than doubled in value since the beginning of 2012.
Having said that, there are some good reasons for Europeans to be concerned about China’s crash. It will have implications for the eurozone’s economic performance.
Direct trade with China may not be the most important transmission mechanism for China’s crisis to reach Europe. Of all EU members, Germany has the largest trade with China. It is driven mainly by Chinese demand for German machinery and cars.
However, even in Germany China accounts for only 6.6 per cent of all exports. To put this into perspective, the US received 8.6 per cent of Germany’s exports and a staggering 68 per cent went to other EU members states.
Slowing Chinese demand for German and European products may therefore be undesirable for Europe, but it will hardly be fatal.
There are several other ways in which China’s problems are more likely to become Europe’s. The first concerns the euro’s exchange rate. It has already appreciated substantially over the past months and China’s troubles make it more likely that this process will continue, especially if the Federal Reserve delays raising interest rates as a result of the China crisis.
For the eurozone, the result is an exchange rate lift, which makes dreams of an export-led recovery less realistic. There was a time in March this year when the euro seemed to be heading towards parity with the US dollar but it is now back at $US1.16. On Monday, as global stockmarkets crumbled, the euro gained more than 2 per cent against the greenback which underlines how much the euro’s value could be shifted upwards by an ongoing crisis in China.
For the European Central Bank, this development must be a concern. Through its policies, not least its quantitative easing program, it is trying to achieve two things: a lower exchange rate and an increase in consumer prices. The fallout from China jeopardises both goals simultaneously as the euro’s higher exchange rate also makes imports cheaper. At the same time, there is little the ECB could do to counter these developments. Its interest rate is zero while its €60 billion-a-month bond-buying programme is already quite aggressive.
In summary, the fallout from China’s crisis promises to be an unpleasant cocktail for the eurozone. It may only put a minor dent into the eurozone economy because of its direct trade links with China. But more importantly, the rising euro exchange rate will dampen all eurozone members’ overall trade performance. This is obviously a problem for highly export-reliant economies such as Germany, but it is a problem too for economies that were hoping for some export stimulus to help them out of their economic stagnation.
Finally, the ability of the European Central Bank to do anything about these developments is severely limited. It has no conventional tools left to stimulate the economy or to shift the price level upwards as is its stated intention. The Bank’s monetary policy is already unorthodox. The question is, how much more unorthodox it would need to become to have an effect? Would it require the Bank to finance government spending directly at some stage?
The eurozone is ill-prepared for the fallout of the China crisis. More than anything else, eurozone economies need growth to deal with unemployment and budget deficits. A world economy slowed down by China, combined with a higher euro exchange rate and falling price levels, will be a challenge to eurozone members, whether they are France, Germany or Greece. They will all feel the impact of China’s problems.
A few weeks ago, I wrote in this column: “The stabilisation of eurozone debt levels, which the European Commission hopes for, also depends on growth picking up across the continent. This does not allow much of a margin for error, and any kind of external shock would derail the attempts at debt stabilisation” (Now for the next euro crisis, 21 July). The China crisis may turn out to be precisely the kind of external shock I alluded to.
At the time the euro was introduced in 1999, Milton Friedman predicted the euro would not survive the first major European recession. In the GFC, Friedman would have been right had it not been for concerted political efforts to keep individual eurozone members afloat through various bailout packages. However, the question is entirely appropriate with regard to whether the euro would survive another global financial crisis.
Should China’s travails turn out to be severe and persisting, they could well have serious implications for Europe.
