Stephen King: How China is putting the skids under Western economic revival

Outlook: In the absence of a collapse in commodity prices, the US and the UK are struggling

In recessions past, the Western economies exported their problems to countries elsewhere in the world. As the US and European economies tripped up, so their demand for raw materials would drop. Commodity prices would plunge. Raw materials producers, mostly to be found in the emerging world, would suddenly find themselves in trouble. Their export earnings would spiral downward, leaving them unable to repay past debts. Currency collapse and debt default typically followed shortly afterwards.

For the emerging nations, this was often a nasty experience but, for the Western economies, it was also part of the healing process. The collapse in commodity prices lowered import costs, cut the cost of living and, hence, boosted people's spending power. By exporting recessionary pressures to other parts of the world, the seeds were sown for a domestic recovery. Lower prices of a range of economic basics – oil, gas, metals, food and non-food agriculture – became a safety valve for both the US and Europe, even while they placed a curse on poorer nations elsewhere. An extreme example is the Latin American debt crisis from 1982 through to 1984.

For the West, this safety valve is no longer working. In the middle of the decade, when Western economies appeared to be performing rather well and the sub-prime crisis appeared only in people's worst nightmares, oil prices hovered around the $30 per barrel level. Had forecasters then known about the coming economic crisis, they would probably have argued that oil prices would subsequently collapse. They would probably have said much the same about the prices of metals and a variety of soft commodities.

And yet prices of all these things are now a lot higher than they were in the middle of the decade, despite the implosion in activity in the Western world. It is true that oil prices are still lower than they were at the peak last year when they threatened to rise beyond $150 per barrel. But, at between $70 and $80 a barrel, oil prices are much more elevated than they were in the middle of the decade, despite the economic crisis which have befallen the Western world since then.

Among the more obvious "financial" explanations for the strength of commodity prices are the weak dollar (commodities are priced in dollars so, if the dollar is soft, commodity prices rise) and speculative activity among investors who increasingly regard commodities as an alternative asset class. Yet these explanations go only so far. The most obvious long-term reason behind the strength of commodity prices is the growing importance of emerging nations such as China, where there is a huge and growing appetite for raw materials.

China's economic progress is re-writing the relationship between the Western economies and the prices of key raw materials. No longer do commodity prices collapse when the Western world hits an economic brick wall. China is now the biggest consumer of metals in the world. It is the second biggest consumer of oil, after the US.

Commodity prices have held up in part because the Chinese economy has done well. Moreover, the primary source of Chinese growth over the last year or so has shifted from exports towards government-sponsored domestic infrastructure spending, a particularly commodity-intensive form of economic growth. With China's economy expanding at an annual rate of around 9 per cent, it's no great surprise that commodity prices are, therefore, relatively elevated.

What does the gravitational pull of China mean for other countries around the world? For commodity-producing nations, it has been generally good news. Canada, Australia, Norway and New Zealand have weathered the economic storm better than other industrialised nations, largely because their prospects have been boosted by higher commodity prices. It is no great surprise that both Australia and Norway have been able to raise interest rates in recent weeks even while other developed nations have continued to depend on monetary life support.

Brazil has also prospered, reflected in persistent upward revisions to consensus forecasts for its economic growth in recent months, although the strength of its currency, the real, has caused sufficient headaches to leave the Brazilian authorities playing around with capital controls.

For the US and Europe, however, the news is not quite so encouraging. Strong Chinese growth will certainly help major capital goods exporters around the world – Germany, most obviously – but China's strength prevents the old-fashioned commodity-price safety valve from kicking in. In the absence of a major collapse in commodity prices, the US and the UK, alongside other financially-challenged nations, are struggling to stage the recoveries of old.

One way to understand this effect is to think about the trade-off between domestic costs and global commodity prices. If the achievement of price stability depends on these two drivers of inflation, an increase in one must be offset by a decrease in the other.

Thus, if China forces global commodity prices higher, domestic costs will now have to be lower to ensure that price stability is achieved. If, in turn, domestic costs move up and down in line with domestic demand, it follows that higher commodity prices will have to be associated with lower domestic growth assuming that inflation is not allowed to drift higher.

Seen this way, China's success is imposing a tax on economies in the developed world. That tax makes recovery more difficult. A home-grown economic crisis stays at home because there is no easy way to export its effects to other parts of the world via the old-fashioned effect on commodity prices.

This is not to say that the Western world cannot recover. Friday, for example, saw the release of some very encouraging US labour-market data which, for the first time in this economic downswing, offered some convincing evidence that the worst may finally be over.

Nevertheless, there is a steep cliff still to be climbed before Western economies return to any sense of normality. Higher commodity prices make that climb so much more difficult. The offset to higher commodity prices will be lower wages, squeezed profits and lower sales than before. Domestic price pressures are likely to subside further: even with higher commodity prices, this will feel more like a deflationary rather than inflationary world in the West. Add to this the need to raise taxes and impose cutbacks on public spending (including public-sector wages) and we're facing an ongoing world of austerity.

The Western world is paying the price both for its earlier greed and for the success of economies elsewhere in the world. Like the marriages of some very famous golfers, this economic crisis will take a long time to heal.

stephen.king@hsbcib.com

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