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growth, World economy

How would a slowdown in China affect the UK economy?

Hereafter an extract from Bank of England’s latest Inflation Report (released on 5 November 2015) describing how a slowdown in China would affect the UK economy.

Bank of England – Chinese grochina1wth has slowed significantly in recent years, from annual rates of around 10% before the crisis, to around 7% currently. Growth is projected to continue to moderate over the MPC’s forecast period, as demand rebalances towards consumption, although there is significant uncertainty about how smooth that rebalancing will be and a risk that growth slows more sharply. This box sets out the channels through which a sharp slowdown in China would affect the United Kingdom, along with some estimates of their size. China plays a significant role in the global economy. It is now the second largest economy, accounting for 13% of global GDP in 2014, compared with less than 2% in 1990 (based on comparisons of countries’ GDP using market exchange rates).

Over that time, China’s trade and financial links with the rest of the world have multiplied. China is the world’s largest goods exporter, and Chinese demand accounts for around 10% of global trade (Chart A). In commodity markets, China has accounted for just over a third of oil demand growth in recent years and the majority of demand growth for copper. Although China’s financial system is relatively closed, its linkages with the global financial system have increased. China’s external liabilities accounted for 6% of world GDP in 2014, compared with an average of 3% during 2005–12.

china3China accounts for only 3% of UK exports so any direct effects of a slowdown on UK output are likely to be relatively small. But a slowing in China would also indirectly reduce UK export demand by weighing on activity in other trading partners. For example, China is an important source of demand for Germany and other European countries, which account for close to 40% of UK exports (Chart A).

As China is also an important source of demand for commodities, a slowdown there would probably be associated with commodity price falls. These falls would, overall, support activity in the United Kingdom and other commodity importers by boosting households’ real incomes. A sharper-than-anticipated slowdown in China could also be reflected in falls in asset prices in China and elsewhere. Such falls may push up UK companies’ cost of capital and reduce households’ wealth. A sharp slowing in China could also raise uncertainty about the outlook for growth there and elsewhere, which may weigh on UK households’ and companies’ spending decisions. The size of these channels is likely to depend on the scale and the nature of the slowing in China: a more severe slowdown could have a significantly greater impact on risk sentiment and uncertainty. A sharp slowing in China could also have on impact on the UK banking sector. UK-owned banks with exposures to China could suffer losses, which in turn, might bear down on their ability to lend to the UK real economy. They could also lead to an increase in banks’ funding costs, particularly if combined with a deterioration in financial market sentiment, which would increase the cost of borrowing for UK businesses and households. The capacity of the UK banking system to maintain lending should these risks materialise will be assessed as part of the Bank of England’s 2015 stress test. Estimates based on a model of the global economy that captures trade, financial and commodity price linkages suggest that, if Chinese GDP were to fall by 3% relative to its trend, UK output would be 0.3% lower as a result (Table 1). Although that model captures China’s current importance in world trade, other channels are based on historical correlations. So, given the growth in China’s interlinkages with the global economy, these estimates may understate the impact of a slowdown in China. Indeed, in recent months global asset prices have been noticeably sensitive to developments in China.

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