Will the West pass debt bomb to China?

As Western economies take dramatic action to cut their yawning deficits, the pressure on China’s economy is likely to grow.

Last week’s data from the Conference Board, which aggregates leading economic indicators, saw China downgrade its key indicator for economic health from 1.7% to just 0.3%, its lowest reading in five months.

The board attributed the downgrade to a ‘calculation error’ and it spooked the market massively, sparking a widespread sell-off in Asian equities. Economists believe this was a signal of a double dip for China, which in turn would drag the global economy back into recession.

China’s domestic exchange, the Shanghai Composite, has had a torrid three months as concerns continue to grow. The index lost 23% in the second quarter and is down by some 27% over the year. It has been by far the weakest market in Asia this year and is one of the weakest in the world.

China’s economic problems are wide ranging. They include the need to cool the debt-fuelled housing boom, sharp rises in labour costs and the impact of the rising yuan.

However, one problem that has possibly been a little overlooked by the market is the implication for Western economies trying to revive their debt-laden balance sheets.

Only two of the major economies in the developed world are running a surplus (see table below). Norway has a surplus of 9.7% of GDP, while Switzerland is 0.7% in the black.

Ireland’s deficit is the most severe at 14.3%, with Greece, the UK, the US and Spain running deficits of 13.5%, 11.3%, 11.2% and 11% respectively.

The aggregate deficits of these major economies is a huge $3 trillion, meaning fiscal tightening measures are essential.  This was reflected in UK chancellor George Osborne’s tough emergency Budget of two weeks ago, in which he vowed the coalition government would wipe out the UK’s deficit, which will rise to £149 billion this year, by 2014/15.

Lombard Odier Darier Hentsch expects the global deficit will be reduced by a third, or $1 trillion, and points out that the net effect of such drastic action will result in the improvement of budget deficits, based on the assumption the private sector will not releverage or reduce its savings.

Lombard Odier analyst Samy Chaar underlined the dynamic: ‘If the Western fiscal position improves and the Western current account improves accordingly, the counterpart will be that external surpluses elsewhere  must deteriorate... in short, Western deficit correction implies Eastern surplus reduction.’