Is risk in eye of the beholder?

The International Monetary Fund's (lMF)latest assessment on the Chinese economy was released on Feb 6 by the IMF Resident Representative Office in China. It included recent developments, the outlook, risks and policy suggestions. Reflecting the worsened external environment since the last update several months ago, China's economic growth for 2012 was revised down to 8.25 percent. But still, China remains a bright spot in the midst of intensifying strains in the euro and fragilities elsewhere.

Steady progress is being made on many fronts. The external current account surplus fell to about 3.3 percent of GDP; monetary policy has been fine tuned; and owing to prudent policies, inflation is now forecast at about 3.3 percent, barring any food supply shocks; and measures to contain speculation in the property market have been successful.

Having said that, China is not without internal risks. Balance sheet deterioration from the slowing real estate and export sectors, and outstanding loans to local government financing platforms could dampen economic activities.

Moreover, recent rebalancing took place largely through a surge in investment, rising from 42 percent of GDP in 2007 to 48 percent in 2011. This raises sustainability questions. Moreover, China is exposed to Europe and other countries through trade. In fact, China's global exposure has risen, with its share in global exports in 2011 rising to 10.5 percent, up from 8.8 percent in 2007.

China's outlook is inevitably tied with the global environment. Most advanced economies will decelerate, and emerging economies will grow at a slower pace. The eurozone economy, on the other hand, is now expected to go into a mild recession weighed down by deleveraging and fiscal consolidation. Global growth is now projected to expand by 3.25 percent in 2012, down by about 0.75 percentage points relative to the September projection.

There are some positive signs, though. The European Central Bank's actions, especially through the three-year longer-term refinancing operations, have eased short-term liquidity pressures in eurozone banks. Besides, the European Financial Stability Facility can now operate both in primary and secondary public debt markets, providing greater flexibility in engagement.

Also, European policymakers have taken significant steps toward deeper fiscal integration and brought forward the starting date of the European Stability Mechanism to July 2012. On the other side of the Atlantic, the latest macroeconomic data in the United States, including payrolls in January, are also better than expected.

However, a fundamental improvement of the global economic fragility requires finding a way out of the negative feedback loop of fiscal consolidation, lower growth and financial sector vulnerability. This requires resolving the legacy of the three highs: public debt, private debt (in advanced economies), and financial leverage. Deleveraging is continuing in the eurozone economies as easier liquidity conditions have not translated into a rebound in credit growth. Banks are under pressure because of sovereign stress and the closure of many private funding channels. That apart, a large amount of sovereign debt will mature in 2012-15.

In the US, the surprise on the upside reflects consumers unexpectedly lowering their savings rate and robust business fixed investment. The fiscal deficit without seasonal factors, could decline by over 2 percentage points of GDP. Also, negative household equities are holding down consumption and labor mobility.

Against this background, the latest IMF World Economic Outlook Update - released last month - examined a possible tail risk emanating from Europe, and spreading to other countries. The source of the risk is an intensification of the adverse feedback loops between sovereign and bank funding pressures, leading to protracted bank deleveraging.

Bank asset quality will deteriorate and bank credit and private investment will further contract. The eurozone activity could fall by 4 percentage points below the baseline. Such a shock could quickly spread to the rest of the world, and trigger latent vulnerabilities in individual countries and regions, mutually enforcing the negative downward spiral.

China will not be immune. In addition to a sharp drop in exports, China's growth could suffer from existing domestic weaknesses as they are more forcefully brought to the forefront. For example, the decline in export earnings in turn will further depress domestic demand and the property market, including its downstream industries.

Deteriorating bank balance sheets could lead to deleveraging, further aggravating corporate stresses. An IMF internal simulation, calibrated on the basis of how external shocks have historically affected its economy, shows that growth in China could fall as much as 4 percentage points below the baseline.

However, unlike many other countries, China has the policy space to contain the negative spillover should such a tail risk ever materialized. A fiscal stimulus package in the order of 3 percent of GDP could hold growth up above 7 percent, as early policy action preempts the triggering of existing domestic vulnerabilities.

Moreover, China could use this opportunity to boost consumption, including through helping the most vulnerable, strengthening household income and social services, and raising transfer payments. This would also help reduce China's reliance on investment and support restoring internal balance.

What can the international community do to support the eurozone economies' efforts to forestall such a tail risk from materializing? Many other countries will not have the policy space to counter such a negative shock and global growth could fall to 2 percent.

International support could help break the negative feedback loop noted above through restoring confidence. This can be achieved by establishing a large enough fund that would forestall concerns of a financing shortfall. In fact, a big enough firewall will restore confidence such that the fund will not have to be used. It may be useful to be prepared in case risk may not just be in the eye of the beholder.

The author is the senior resident representative of the IMF in China.

(China Daily 02/21/2012 page9)