IMD Professor Reacts
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Despite slowing growth, China is unlikely to cause a global slowdown

Why IMD Professor Nuno Fernandes is not overly concerned about the IMF’s analysis

By Nuno Fernandes

February's sudden slump in Chinese exports prompted IMF deputy chief David Lipton to warn that next April's projections for global growth will very likely drop below the current prediction of 3.5%. Some experts now think worldwide growth could fall below 3%. The recalculation is due in large part to slow growth in China, which is now at its lowest point in 25 years. Noting that the IMF is reacting to a weakened base line, Lipton observed, "We are clearly at a delicate juncture."  

The reassessment is due in part to the news that Chinese exports in February had declined by an astonishing 25.4% compared to the same period a year earlier. Analysts had predicted a drop in exports, but had expected it to be only around 15%.

The unexpectedly sharp fall, combined with a dramatic sell-off on the Shanghai and Shenzhen stock exchanges a month earlier, sparked new concerns that China’s role as "factory to the world" is beginning to go off the rails. The obvious concern is that China’s slowdown might lead to a new global financial crisis similar to the one caused by the subprime mortgage debacle in the US. While recent events in China clearly warrant close attention, a replay of the massive global slowdown of 2008 is highly unlikely.

A major reason for not being overly concerned is that in contrast to Europe and the US, China still has plenty of economic firepower. It has more than enough resources to deal with any immediate problems resulting from the difficult transition to a more sustainable growth rate.

While central banks in Europe and the Federal Reserve in the US long ago reduced interest rates to near zero and engaged in multiple bouts of quantitative easing, China still has numerous options that it can ball back on. Even Moody’s, which recently downgraded China’s outlook from “stable” to “negative”, continues to give China an Aaa3 credit rating.

In contrast to Western countries running huge deficits, China's budget deficit is only around 3%. It has enormous cash reserves, and if it wants to increase exports and boost employment, it can easily devalue the renminbi by as much as 10%. In contrast to the West which emphasizes profit and is desperately trying to cope with the downside of globalization, China’s top priority is to head off civil unrest, and safeguard its fragile social fabric. It is willing to operate at a loss in order to maintain stability, and at least for the moment, it has more than enough resources to do that.  

While the IMF’s reassessment may be unwarranted in bringing extrapolated fears on whether or China may cause a global crisis, it does signal that very real changes are taking place. And these changes have a clear impact on the business environment.

The February decline in exports may have been partially exaggerated by extended Chinese New Year’s celebrations in which many workers go on vacation and business tends to be put off for a month, but it was also affected to a certain extent by an accelerating trend to "on shoring," which is returning a significant amount of manufacturing to its home base. The trend is particularly apparent in the US where improvements in technology and the introduction of new, more efficient business processes makes it less expensive to manufacture domestically than to deal with complicated supply chain issues and the inevitable lag in transport from China.  

Rising wages and a more demanding Chinese labor force have also taken the sheen off many of the incentives that previously made China an obvious choice for low cost manufacturing. The shift away from a heavy dependence on exports is compensated to some extent by a rapid expansion of China’s domestic market which is responding to a rapidly expanding middle class.  

In the final analysis, China currently accounts for roughly 10% of the world’s exports and 8% of its global imports. Even if China were to drop out completely, 90% of the world’s commerce would still be there to take up the slack. In contrast to exports, the dollar amount of China’s imports in February dropped by only 13.8%, and part of that decline was due to a global fall in commodity prices, especially oil. The expectation is that a decrease in Chinese imports will probably have the greatest impact in Asia, and among exporters of commodities, particularly Australia and the Middle East. Luxury goods may also experience a drop off. The impact on companies in the US and Western Europe is expected to be minimal. Although it is difficult to come up with a precise figure the actual impact is likely to be less than a half percent.

All that means that China still has considerable breathing space to institute badly needed reforms. Chief among these is a transition from an over reliance on infrastructure projects which create jobs, but produce little in the way of quantifiable financial returns. Unrealistic investments in real estate have managed to keep some of the population working, but it has also resulted in hundreds of uninhabited “ghost cities” that may eventually be headed for the demolition heap. In the next year or so, China will need to wean off the regional governments, municipal administrations and non-productive state-owned companies that are currently supported for political reasons, but which produce little or no return on investment. Shadow banking also needs to be brought under control, and the financial system will have to become much less opaque if investor confidence is to be restored.

The growing consumer economy in China has created an attractive market which will ensure a growth rate of probably between 4-5% a year, which is lower than Beijing’s current target of 6.5-7% a year, but still more than double the projected growth in more mature economies such as the US or Europe. The IMF reassessment and any analysis on downturn in China simply are indicators that the environment has changed. The major difference is that from now on, business in China will require a more nuanced strategy and better analysis than the heady days of double digit growth, when almost any enterprise could easily turn a profit. Though a global slowdown is unlikely, the rules have changed.

This article first appeared in Fortune.

Nuno Fernandes is Director of the Strategic Finance program at IMD business school in Switzerland.


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