Assessing the Economic Effects of the Coronavirus

by Phillip Orchard – February 11, 2020 Geopolitical Futures

There’s irony in the fact that, as Chinese Vice Premier Liu He was in Washington on Jan. 15 signing
the “phase one” deal formalizing the impasse in the U.S.-China trade war, a stealthier threat to
global trade was spiraling out of control at home. Over the past few weeks, the mysterious new
coronavirus epidemic has begun to do what tariffs never quite could. The scramble to contain
the outbreak has shut down Chinese factories en masse, put China on the brink of twin financial and
political crises, and sent foreign executives scurrying to revisit plans to pull out of the country. And
now, with the U.S. and other major economies imposing strict border controls and bans on travel in
and out of China, the flow of Chinese goods to its most important consumer markets is at risk of
nose-diving.

The severity of potential economic disruption – both for China and the world – is impossible to
forecast. (Not that that’s stopped anyone from trying.) The impact will depend mostly on just how
much worse the outbreak gets, which itself can hinge on the evolutionary vagaries of
microorganisms. There’s also unpredictable factors as varied as the ability of oil exporters to agree
on production cuts, ethnic tensions involving Chinese tourists in Southeast Asia and the medium term
investment plans of tens of thousands of businesses. Perhaps the most pernicious is fear – the
sort that was emptying out airplanes even before the travel bans kicked in.

We can say this: Absent a mutation in the virus that accelerates both its spread and lethality or the
eruption of another black swan event, most of the economic damage will likely be short-lived. And
most of the hardest-hit sectors will be primed for turbocharged recoveries. But there are certain risks
where a rupture would cause colossal long-term damage. And, at minimum, the crisis will expedite a
profound paradigm shift about the wiring of the global economy.

Short-term Pain

The most direct comparison to the current pandemic is the SARS outbreak in 2003, which dinged
Chinese gross domestic product by as much as $40 billion, reducing annual growth by between 1
and 2 percent. Globally, the bill for the pandemic ran up to as much as $100 billion. Within a year,
China had returned to pre-outbreak growth levels.

But this benchmark tells us only so much. With the new virus, which originated in Wuhan, the scale of the lockdown has been much wider. It would be painful enough if it extended only to the
outbreak’s epicenter in Hubei province – an area with the population of Argentina and the GDP of
Sweden – which functions as a rail and shipping hub that’s vital to the government’s efforts to stitch
together the wealthier coastal provinces and the interior (a core Chinese imperative). But the
lockdown was extended nationwide, and disruptive quarantine measures have been reported across
the country, including all-important advanced manufacturing hubs like Shenzhen, Guangzhou and
Shanghai that were most affected by the trade war. Moreover, a lot has changed in China since
2003. The population is older, more urbanized, more dependent on internal consumption, and more
reliant on vast internal flows of migrant labor – all factors that can amplify both the spread of the
virus and the extent of its disruption.

As a result, the coronavirus has hit the global economy with three main waves: The most immediate
was Chinese consumption (nearly 40 percent of Chinese GDP in 2018), as hundreds of millions of
people canceled Lunar New Year travel plans; restaurants, shopping malls and movie theaters were
suddenly emptied; and so on. This is also a problem for foreign firms like Starbucks and Walmart
that have pegged their growth strategies to the growing appetites of Chinese spenders, as well as
countries such Cambodia and Thailand that have come to economically rely on Chinese tourists.

The second was labor disruption. Today, China is home to an estimated 288 million migrant
workers, or roughly one-third of the country’s total labor force, most of whom return to their
hometowns during the New Year. Though most Chinese factories outside Hubei were allowed to go
back to work this week, operations won’t reach full speed until travel restrictions and fear subside.

The third wave hit as countries throughout the world (plus, crucially, Hong Kong) started to impose
restrictions on travel to and from China. This highlights perhaps the biggest difference between
today and 2003: China is much more tightly integrated with the world – and, despite halting U.S.
efforts to pare back this interdependence, at the center of a dizzying network of supply chains
optimized overwhelmingly for efficiency, not resilience. Shutting down cross-border travel impedes
business and decimates tourism, of course, but it also hampers shipping, as “belly cargo” on
commercial flights accounts for more than half of air freight.

The worst-case scenario for global trade is that the contagion risks will compel the U.S. and Europe
to ban not just commercial air travel but oceanic shipping as well. This is highly unlikely; the virus
can’t survive on surfaces for long, particularly not a months-long journey, and the relatively small
number of crew arriving at ports won’t overwhelm their health screening capacity. Still, Chinese ports
can’t operate without stevedores, nor ships without sailors. As a result, even without a sweeping ban on shipping, Chinese port activity has slowed by an estimated 20 percent since mid-January. This is a problem for exporters foreign and domestic in China, as well as for commodity exporters like oil
producers, and manufacturing operations elsewhere that depend on intermediate goods made in
China. (This was a side effect of most of the U.S. tariffs as well.) Auto assembly operations in Japan
and South Korea have already been suspended because of a shortage of parts, for example. Some
450 U.S. companies source components from Hubei province alone.

Long-term Risks

The short-term impact may be immense, but as with the SARS epidemic, there’s minimal structural
damage being done to the Chinese economy, and most affected sectors will bounce back within a
matter of months. This isn’t always the case with black swan events. The 2011 floods in Thailand,
where investors had already been spooked by cycles of mass political violence, wiped out hundreds
of thousands of cars from automaker inventories and shut down critical infrastructure for nearly a
year. Japan still has yet to fully recover from the Fukushima disaster. But unlike natural disasters,
conflicts and other more destructive black swans, the fallout from epidemics is comparatively easy to
manage. Factories and public transportation lines in China are closed, not buried under rubble or
coated in radioactive fallout. Hundreds of millions of people may be stuck at home, but the virus isn’t
exactly wiping out the Chinese labor force for good. There’s little stopping key pillars of the Chinese
economy like fixed-asset investment and the services sector from rebounding quickly, especially as
the government opens the stimulus spigots. And China-centric supply chains can’t be rerouted
quickly or cheaply enough for the country to be replaced in the meantime. Moreover, Chinese
manufacturing grinds to a halt every year during the Lunar New Year, typically taking weeks to
return to full production. Most importers of Chinese goods had likely already stocked up in
anticipation. From this perspective, the epidemic came at a pretty good time.

Still, there are three key long-term risks to watch. The first is the trade war. China was already likely
to struggle to meet the import pledges it made in the “phase one” deal. To be sure, the epidemic
(and ongoing problems with African swine fever and a new strain of the avian flu) will likely
compel it to buy more U.S. farm products. But imports of other U.S. goods, particularly crude and
liquefied natural gas, won’t be as necessary, and government funds earmarked to help Chinese
importers meet the targets may have to be diverted to short-term rescue measures at home. China
may have a good excuse if it falls short when the U.S. conducts its reviews of Chinese progress on
implementing phase one in the fall. But whether the White House responds to such a scenario
charitably or restarts the trade war may depend entirely on election-year political factors. At
minimum, the outbreak will force Beijing to lean more heavily on things like subsidies and state-owned
enterprises.

A return to currency manipulation is also possible, though fairly unlikely. This means the already
low chances of progress on negotiating a phase two deal – the one that would ostensibly
address the fundamental drivers of U.S.-China trade tensions – are dropping further.

The second risk to watch is the one keeping Chinese leaders awake at night the most: that even
short-term pain in one vulnerable sector or another will trigger a cascading crisis. Put simply, the
Chinese economy is overwhelmed with interlocking risks, from unchecked shadow lending to a
fragile banking system to widespread asset bubbles. As a result, deleveraging and “financial derisking”
have been the foremost priority for Beijing over the past few years. It’s had enough success
with efforts like metabolizing nonperforming loans, curbing reckless lending and rescuing ailing
banks to prevent an uncontainable crisis from rupturing. But the limits of its ability to micromanage
the economy have also been exposed, with Beijing often finding itself playing a sort of high-stakes
game of whack-a-mole, where its efforts to address one problem worsen a problem somewhere
else. In its campaign to stem a wave of bond defaults among small and medium-size enterprises, for
example, it’s struggled to force banks to lend to troubled firms.

Today, SMEs account for roughly 60 percent of the Chinese economy, plus around 80 percent
of Chinese jobs. Compared to state-owned firms and private sector giants, SMEs are ill-suited to
survive the cash-flow hits that result from the outbreak; in a recent survey, around a third said
they couldn’t last more than a month on their current savings. In response, Beijing is redoubling
efforts to push banks to lend to the sector and reducing interest rates, but these measures will
further weaken balance sheets across the banking system, which is already teetering amid a string
of near-failures in 2019. Beijing is also cutting taxes, which will worsen the default risks posed by
debt-ridden local governments (which Beijing is now allowing to pile up new debt to spur
infrastructure spending). It’s cutting pension contribution requirements, which will amplify China’s
demographic crisis. It even appears to be easing off its shadow lending crackdown. So even if
China avoids a financial meltdown now, its moves will increase the risk of a crisis over the long term.
Keep in mind that China was racing to eradicate these risks – and, as a result, loath to flood the
economy with fiscal stimulus – before the next global recession. That’s still looming.

A Death Knell for Interdependence

Finally, the epidemic will make other countries more wary of China’s outsize role in global
manufacturing. Since the 1990s, the cutthroat economics of globalization have pushed supply
chains to become ever more complex and geographically diverse. For example, the Jeep Cherokee, the most “American-made” automobile in 2019, is built with components sourced from dozens of
countries. But these economics have also pushed for the manufacturing of particular components,
particularly research-intensive high-end technologies, to be consolidated in one or two countries.
The result has been the proliferation of chokepoints.

It’s not just China. Taiwan dominates semiconductor fabrication. Japan, as we saw last summer
in its dispute with South Korea, dominates production of various chipmaking materials. The U.S.
is currently mulling how to leverage its dominance over chip design, software and the dollar denominated
global financial system to blunt China’s technological rise. But China has certainly
made itself the king of chokepoints. And chokepoints can be really bad for business.

The U.S.-China trade war and “tech war” have underscored just how much supply chain
bottlenecks can be weaponized or targeted for strategic or political purposes – and how easy it is for
firms to be caught in the crossfire. Likewise China’s crackdowns in Xinjiang and Hong Kong.
The coronavirus outbreak, along with the problems endemic to the Communist Party’s model of
governance its exposed, has merely crystallized the risk of being dependent on China that much
more. China isn’t the only manufacturing center vulnerable to epidemics, natural disasters, political
spasms or geopolitical disruption. But until its relationship with the West finds stable long-term
footing, and until its government can be confident in its long-term hold on power, China will be home
to the most tightly concentrated and explosive matrix of supply chain risks.

This doesn’t portend a future of total Chinese isolation from global supply chains. Its manufacturing
footprint and labor pool are extremely difficult to replace at scale, while the lure of access to
Chinese consumers alone is enough to give most multinational corporations pause. Surveys indicate
that most firms planning to leave China are doing so only partially, with the goal of effectively setting
up parallel supply chains as a means to inoculate themselves from tariffs, Beijing’s capacity for
coercion and whatever black swans may come. Firms may be merely seeking to protect themselves
from events beyond their control. But the broader effect will be an accelerated if fitful disentangling
of the chains binding Chinese and Western countries. This is a dramatic reversal of a more than 30-
year trend with any number of potential geopolitical implications – the ability of nation-states to
weaponize interdependence chief among them.

Download PDF Here