What happens if the US and China tighten credit simultaneously?

The US and Chinese central banks have reasons for starting to reduce the credit they're pushing into the economy. The risk is that this double-whammy of tightening will be greater than the sum of its parts, weighing on economic growth worldwide.  

Confidence in global economic recovery is wavering after a jolting one-two punch that has driven markets down around the world.

Stock prices fell and bond rates rose late last week after comments from Fed Chairman Ben Bernanke sparked concern that the US central bank would scale back its stimulus plans. On Monday, stock markets around the world moved down again sharply as reports circulated that the Chinese government may have decided to either allow or actually encourage a liquidity squeeze, which threatens to curb economic growth in China and throughout Asia.

One highly visible sign of the changing times came Monday when Chinese stock prices suffered their largest declines since August 2009. China’s CSI 300 Index, made up of the 300 biggest companies in the Shanghai and Shenzhen stock exchanges, lost 6.3 percent. This latest drop puts the index 22 percent below this year’s high and firmly in bear market territory.

Behind the Chinese market plunge is mounting fear that China’s central bank will respond not by easing credit but instead by extending new tighter credit standards. The result could be a worsening liquidity crunch that could affect markets and economies worldwide. According to analysts at Moody's Investors Service, the Chinese central bank may have made “a conscious decision” to curb credit growth in China by deliberately reining in the country’s shadow banking system.

Another sign of trouble on the Chinese horizon came Sunday when Goldman Sachs reduced its forecast for growth in China. Its report forecast that China’s gross domestic product (GDP) would rise 7.4 percent this year, down from its earlier forecast of 7.8 percent. The report forecast 7.7 percent GDP growth for 2014, down from 8.4 percent. In the report, economist Li Cui warned that “The recent tightening of the interbank market has sent a strong policy signal that the strong credit growth earlier in the year will likely not continue.”

The Goldman Sachs downgrade follows similar recent reports from HSBC, Morgan Stanley, and UBS. Earlier this month, Goldman Sachs China strategist Jiming Ha reported that “China has basically said goodbye to 8.0 percent GDP growth in spirit, if not in statistics, and will have to embrace slower growth, with the average annual growth rate in the next seven years to 2020 perhaps falling to the vicinity of 6.0 percent.”

The next round of reports to watch for will focus on calculating the extent to which tightening credit in China and trimming back the Fed’s $85-billion-per-month stimulus program at the same time will sink prospects for healthy growth in the world economy. The concern is that the combination of the tightening actions in the world’s two largest economies will have a sum that is greater than its parts.

But calculating the potential impact is complicated by the fact that the calculations will be highly speculative since no combination of this magnitude has taken place in the past.

Trouble lies ahead, Vasu Menon, head of content and research at OCBC Bank Ltd. in Singapore, told Bloomberg TV. “Volatility is going to be the order of the week for the markets. China has had a credit binge for way too long. The government is trying to rebalance the economy, trying to downsize the shadow banking system. All that means credit is going to remain fairly tight.”