What will happen to activity and inflation in the US if the Chinese real estate sector leads to a crisis? - Liberty Street Economics

Ozge Akinci, Hunter Clark, Jeff Dawson, Matthew Higgins, Silvia Miranda-Agrippino, Ethan Nourbash, and Ramya Nallamotu provided an analysis of the potential consequences for growth and inflation in the U.S. in the event of a worsening crisis in the Chinese real estate market. The study examines the possibility that the ongoing downturn in China's real estate sector could lead to a deep economic recession and financial crisis.

In this scenario

The policies of the Chinese authorities will prove insufficient to prevent a deep and prolonged economic downturn. In previous studies, the authors examined the political landscape of China and its potential limitations. China's policies are based on the unique characteristics of the country's political and financial systems, such as direct and indirect control over the financial and non-financial sectors of the economy. The Chinese economy is also shielded from external shocks due to a balanced current account, large currency reserves, and an investment system. Overall, the Chinese authorities have the ability to use monetary, credit, and fiscal policies to smooth out economic fluctuations. However, this policy space is becoming increasingly constrained as debt accumulates.

Key factor

A further destabilization of the real estate sector is a negative scenario. Since the beginning of 2020, new construction and real estate sales have decreased by half and a third, respectively. Lending to developers has almost completely stopped, and then resumed in a limited capacity after improvements in government policy regarding lending in the real estate sector. It is highly likely that further destabilization in the real estate sector will lead to a further reduction in construction activity and a weakening of fiscal policy at the local level.

The role of the real estate sector in China's economy makes it a likely catalyst for economic downturn and financial crisis. Until the downturn, the real estate sector accounted for about a quarter of China's GDP and still represents a significant part of the economy. Real estate-related loans still make up about a quarter of the total debt, and real estate constitutes about two-thirds of household assets. It is not surprising that the downturn in the real estate sector is accompanied by a serious decline in business and household confidence.

Assuming a worsening crisis in the real estate market, China's GDP growth is projected to drop to zero in 2024, followed by a weakened recovery to 2 percent the following year. Credit growth is also decreasing compared to the baseline scenario. To assess the impact of this negative scenario on the U.S. economy, the authors use a Bayesian VAR model, which evaluates the historical dynamics of the relationships between the American and Chinese economies. The scenario model is built on data from the International Monetary Fund (IMF), where Chinese productivity and credit growth are constrained according to the authors' described scenarios.

The results show that a sharp economic downturn in China could lead to a decrease in growth and American trade activity, as well as a reduction in inflation.

The scale of these consequences is greater than in previous studies suggesting a manufacturing boom in China, which aligns with a significant deviation of GDP growth from the baseline scenario. The impact is based on the same mechanisms but works in the opposite direction. A sharp decline in Chinese domestic demand leads to a steep drop in global commodity prices and China's exports. This effect is linked to China's key role in international trade and production networks. Weak demand from China results in reduced demand from its value chain partners, which is exacerbated by the tightening access to financing for these companies. The overall decline in global trade, of course, reflects a similar decrease in the volume of American foreign trade. At the same time, the US dollar strengthens significantly in accordance with its long-term negative correlation with global commodity prices. In the context of our real estate market crisis scenario, such strengthening can be understood as a manifestation of more cautious behavior from global investors seeking refuge in the US financial market and in dollar assets. A strong dollar, in turn, contributes to the tightening of global financial conditions. In fact, the primary impact of reduced demand in China on global financial conditions occurs through this indirect channel.

In conclusion, the realization of a crisis scenario in the Chinese real estate market would tilt the balance of risks for growth and inflation in the U.S. towards a negative scenario. However, Chinese authorities have sufficient tools to contain new negative pressures on the country's economy. Currently, we consider the implementation of this scenario to be unlikely compared to a scenario of a manufacturing boom. Both scenarios, of course, imply different political implications. A deep recession in China would contribute to a decrease in inflation in the U.S. and strengthen investor expectations for easing policies. In the case of significantly faster growth in China, there would be challenges in achieving inflation targets set by central banks, which, in turn, would push back investor expectations for policy easing to a later date.