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Macro View: China’s malaise may be more troubling than Greek crisis

AS the Greek drama continues to unfold, threatening to unleash huge economic damage, the collapse in Chinese share prices highlights problems that could have worse medium term consequences.

It is unclear how the Greek saga will end. As the dispute between Greece and its creditors is becoming dominated by political considerations, a truly positive outcome is unlikely. The conclusive “NO” vote in the Greek referendum will make it hard to reform its tax system, civil service and pensions regime. An acrimonious Grexit could be the most dangerous result. But the best outcome would be an amicable Greek euro exit, with generous EU support, which would enable Greece to deal with its problems.

So far, all sides oppose this option. Greek politicians have failed to explain to their electorate that using the euro entails costs that far exceed the benefits, while eurozone leaders adhere to the misguided dogma that any departure from the euro is inconceivable, because it threatens the very existence of the single currency. But there are tentative signs that a mutually agreed Greek exit may be considered.

The current crisis mainly focuses on Greece’s huge debts and massive budget deficit. But the unsustainable fiscal gap is not the only problem. Greece also suffers from a severe lack of competitiveness. To become competitive, Greece must devalue its currency, i.e. leave the euro at least temporarily or, alternatively, accept a prolonged period of falling wages and living standards, until unit labour costs are no longer higher than in other euro members. Unless competitiveness is restored, any help given to Greece will only offer temporary debt relief but will not address the fundamentals.

Lack of competitiveness is also an issue for other eurozone countries, and this may cause instability in the future. But Greece’s problems are more severe and immediate. If Greece is more flexible in the negotiations, it will be possible to avoid a rancorous Grexit, but securing a lasting agreement will be very difficult. The most likely result is yet another unsatisfactory deal, which will only postpone the next crisis. This will be preferable to a forced and bitter Grexit, driven by default, which could unleash banking turmoil and could abort the fragile eurozone recovery. Big uncertainties will persist for some time.

Economic conditions in the eurozone have continued to improve in spite of the Greek crisis. The monthly survey of purchasing managers rose in May at its fastest rate in four years, indicating healthy economic activity. If a major Greek bust-up is avoided, the eurozone’s slow progress will continue. But with an unemployment rate of 11.1%, and with weaker growth than in the UK and the US, the eurozone recovery is still fragile and not yet secure.

The role of the ECB will remain critical. Any arrangement with Greece, however imperfect, will require ECB support. Official eurozone interest rates will remain at their current exceptionally low level for the foreseeable future. The aggressive QE plan, which on present plans will run until September 2016, will be maintained. President Mario Draghi may wish to increase QE if renewed Greek tensions threaten the euro, but such a move may trigger German opposition.

Something more sinister

Having become accustomed in recent years to China’s persistent problems of excessive debt, it took investors some time to realise that the plunge in Chinese share prices, which fell more than 30% before recovering somewhat, may signal something more sinister than the unwinding of a market bubble. The drastic response of the Chinese authorities, which provided financial support and imposed severe limits on normal trading, shows that they were sufficiently worried to act in a manner that appeared an over-reaction.

The official measures helped to stabilise share prices, at least temporarily. But the underlying significance of the drop in prices will remain unclear for some time, depending on the view one takes on China’s fundamental economic health. This is a big debate, which will not be resolved quickly. For the optimists, the recent upheaval was a transitory blip. But others fear that the market collapse signals a deeper malaise, which may foreshadow a hard landing and a sharp economic slowdown.

Senior Chinese leaders have recognized over the years the need to move to a more balanced economic model, which relies less on investment, exports and the build-up of debt. But the transition is proving difficult. Rebalancing and relying more on consumer spending entails slower growth; this generates opposition amongst vested interests and is politically tricky to manage. The slowdown in Chinese growth, from well above 10% per annum in the previous decade to a range of 7-8% in recent years has been relatively smooth. But huge economic distortions persist, and reducing growth further to a range of 6-7% per annum will prove to be more difficult. Our central forecast assumes that China would remain a fast-growing thriving economy. But recent events are a warning that success cannot be guaranteed.

Mediocre US growth

The US economy continues to grow at a mediocre pace. Weak GDP in the first quarter will adversely affect US performance in 2015. But the fall in output early this year was only 0.2% annualised, less than the 0.7% decline previously estimated. Our full-year US GDP growth in 2015 is therefore revised up slightly, to 2.4%. While this is disappointing by historical standards, the Federal Reserve is likely to go ahead with its plans to start raising official interest rates in the next few months.

Although core annual inflation fell from 1.8% in April to 1.7% in May, the figure is sufficiently near the 2% unofficial target to persuade Fed chairwoman Janet Yellen that modest monetary tightening would soon be justified. The US job figures, though middling, will support on balance the case for a small rate rise. Employment rose in June by 223,000, an acceptable figure, but the May increase was revised down from 280.000 to 254,000. Despite slower growth in June jobs, the US jobless rate fell to 5.3% in June from 5.5% in May. Though this was in part due to people dropping out of the labour force, it also signals falling spare capacity and supports the case for higher US rates.

In the UK the economic news was mixed. On the positive side, GDP growth in 2014 was revised from 2.8 to 3% and growth in the first quarter of 2015 was raised from 0.3 to 0.4%. Moreover, the UK labour market remains strong, with employment rising and unemployment falling. However, the current account deficit in the first quarter of 2015 was 5.7% of GDP, an unacceptable and dangerous level.

Following the Conservative victory in the May elections, chancellor George Osborne presented in July a Summer Budget. It contains useful business-supporting measures and a smoother path to cutting the deficit, which will benefit growth. But there is a big increase in the national minimum wage, rebranded as a ‘National Living Wage’, which could threaten job creation and endanger many SMEs, if it is not enforced in a sensible manner that reflects increases in productivity.

David Kern of Kern Consulting is chief economist at the British Chambers of Commerce. He was formerly NatWest Group chief economist.

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