BOE inflation report: U.K. economy will be hit hard if China slows further

The Bank of England in its November inflation report highlighted that the U.K. economy will take a serious blow if China suffers a hard landing.

China accounts for just 3% of U.K. exports, thus any direct effects of a slowdown on U.K. output will likely be quite small. But a slowing in China would also indirectly lower U.K. export demand by weighing on activity in other trading partners, the report states. For instance, China is an important source of demand for Germany and other European countries, which account for nearly 40% of U.K. exports.

A slowdown in China would possibly be associated with commodity price falls, since China is a significant source of demand for commodities. These falls would, overall, support activity in the United Kingdom and other commodity importers by driving households’ real incomes.

A heavier than expected slowdown in China could also result in falls in China's asset prices. Such drops may push up U.K. companies’ cost of capital and reduce households’ wealth. China's steep slowing could also spur uncertainty about the outlook for China's and global growth, which may weigh on U.K. households’ and companies’ spending decisions.

The size of these channels is likely to depend on the scale and the nature of the slowing in China. A more severe slowdown could have a way bigger influence on risk sentiment and uncertainty, the report says.

A sharp slowing in China could also have on impact on the U.K. banking sector. UK-owned lenders with exposures to China could suffer losses, which in turn, might bear down on the ability to lend to the U.K. real economy. They could also lead to a rise in banks’ funding costs, especially if combined with a worsening in financial market sentiment, which would drive up the cost of borrowing for U.K. companies and households. The capacity of the U.K. banking system to maintain lending should these risks materialize will be assessed as part of the Bank of England’s 2015 stress test.

Calculations based on a model of the global economy that captures trade, financial and commodity price linkages suggest that, if Chinese GDP were to drop by 3% relative to its trend, U.K. output would be 0.3% lower as a result.