By Manu Bhaskaran, Asia Economist and CEO of Centennial Advisors

As export growth also falters and adds to the depressing demand outlook, deflationary pressures could be growing, as production is shaky, as shown in Charts 1 and 2. Industrial production growth slowed to 3.5% year on year in May 2023 from 5.6% in April.

A weak job market is likely to worry policy makers: Although overall unemployment held steady at 5.2% in May because of government work relief programmes, youth unemployment rose to a new record high of 20.8% in May.

A weak property sector adds to the downside risks: Real estate investments contracted 7.2% year on year in Jan-May 2023 worsening from Jan-Apr 2023’s -6.2%. New construction starts by floor space fell further, down 22.6% in Jan-May 2023 and home sales by floor space contracted by 0.9% in the same period.

In essence, a weaker economy is causing a loss of confidence which could then deepen the malaise hitting the economy, with possible deflationary pressures and politically sensitive segments of the work force feeling unhappy. There is little doubt that policy support is needed.

What can we expect from policy makers?

The media is reporting that policy makers are preparing new measures to stimulate the economy. The National Development and Reform Commission has announced 22 new measures to lower costs for businesses, such as tax breaks and reduced interest rates while the country’s six largest banks cut rates with the central bank following by trimming short-term and medium-term lending rates.

However, the scale of policy action is likely to be restrained for a number of reasons:

First, there is insufficient fiscal policy space at the local government level to implement large-scale fiscal stimulus. Local governments derive most of their revenues from land sales which have been depressed by the weak real estate market. As of April, land sales revenue was still 21.5% below the pre-pandemic average. Many local governments are said to be in financial difficulties and are not able to take the lead on fiscal stimulus.

Second, the central government is hesitant to provide a large stimulus because it feels that much of China’s financial difficulties stem from too much stimulus in the past, particularly after the 2008 financial crisis. Finally, China’s leaders seem to prioritise the reduction of imbalances in the economy – such as excessive debt and over-reliance on the real estate sector to generate growth – and fear that large stimulus efforts will go against this objective.

In conclusion, policymakers may aim for a managed slowdown instead of reinvigorating growth to the robust pace before the pandemic. However, the risk is that China suffers prolonged economic weakness and deflationary pressures as a result.

2. Monetary tightening is reaching an end but don’t celebrate just yet

While there is still some debate over whether the US Federal Reserve will raise rates again, there is little doubt that they are reaching the end of their tightening cycle. Other major central banks such as the European Central Bank are still raising rates but they, too, appear to be reaching a point where they may pause. Yet other important central banks such as the People's Bank of China are cutting rates and easing policy.

Why risks have risen

The rapid collapse of Silicon Valley Bank and other regional banks came with little warning. Within weeks, the jitters hammered the financial standing of Credit Suisse, one of the world’s systemically important banks. Credit Suisse had to be rescued through a merger with its rival, UBS. Confidence is fragile and can be lost very quickly whereupon funding can dry up and spark off crises even in institutions which appear to be sound by conventional metrics.

This is why a key concern for us is the longer-term consequences of one of the sharpest monetary tightening cycles we have ever seen since 1980 (Chart 3). The US policy interest rate is 500 basis points higher than two years ago and that has worked its way through global financial markets, pressuring upwards interest rates virtually everywhere. At the same time, the Fed is also reducing the size of its balance sheet, which means that it is also withdrawing liquidity from financial markets. The resulting spate of financial stresses as evident in the failure of regional banks in the US such as Silicon Valley Bank has ripple effects on risk premia for emerging economies as well, hurting them (Chart 4).

As a result, there are several potential flash points in global finance:

Commercial real estate in several countries is one such point of danger. High vacancy rates in the US have led to landlords returning assets back to their lending banks at a considerable loss. In much of Europe, real estate-backed bonds were trading at distressed levels in June as investors feared that these firms would be unable to repay the large amount of debt coming due.

Surveys such as the Fed’s survey of senior loan officers show that lending standards are being tightened, especially for small businesses. That has contributed to a decline in small businesses’ confidence, hurting their hiring and capital spending plans.

The combination of higher rates and a stronger US Dollar is hammering emerging economies that borrowed in US Dollars. Note that financial crises in emerging economies tend to coincide with periods of tightening global monetary conditions like what we are seeing today – recall the Latin American debt defaults in the 1980s, the Mexican financial debacle in 1994, and Brazil’s difficulties in the 2000s. We have already seen Sri Lanka’s economy tip over into crisis while financial distress threatens others including Pakistan, Egypt, El Salvador and Ghana. The last is enduring its worst economic crisis in a generation. More such crises are likely in the coming months.

Should we fear a financial crisis?

What helps the global financial system is the strengthening of capital buffers in global banks since the 2008 financial crisis. Strengthened regulation and supervision after that crisis has also reduced the chances that bank failures might spark off another global crisis. Moreover, financial balance sheets of the household sector are more robust today, which also helps provide a buffer against a crisis.

However, history tells us that long periods of ultra-low rates and easy money tend to encourage excessive risk taking and speculation with the imbalances thus created usually hidden until it is very late in the day. Just as no one saw the speedy collapse of US regional banks, there is a realistic possibility of further episodes of financial stress which will hurt asset markets as well as pose risks to the world economy.