January 31, 2014 7:00 pm JST

Frederic Neumann: Soft landing for China might not be so bad


There's been a bit of troubling news lately -- China's economy appears to be shifting down.

     True, gross domestic product growth in the fourth quarter expanded at a respectable pace. But look more closely and a sharper deceleration appears to be in the cards: The manufacturing sector has likely been contracting this month, investment cooled in December, rising interest rates pose headaches and a wobbly trust product has dominated the headlines.

     Inevitably, the question arises: If China stumbles, what will be the impact on the rest of the world? There are no easy answers to that one.

     Let's get one thing straight. Despite its recent travails, the Chinese economy continues to expand at a robust pace. Most analysts expect a mild slowdown this year to 7.4% growth from 7.7% in 2013. Given the economy's larger base, despite its slowdown, it will still add more to global demand this year than last year, with growth roughly equivalent to the total output of Switzerland.

     Impressive stuff. But it also works the other way round. What if China trips up and slows more sharply than forecast? A sudden stall would eliminate a lot of incremental demand; an outright contraction would leave a huge hole. No wonder, then, that investors are getting nervous at even the slightest sign of cooling growth. But expectations veer between boom and bust, distracting from calmer deliberations about what a slowing China might mean to the world economy.

     Here's how to think about the China risk to global growth. First: No Lehman moment. Yes, China's economy is now comfortably the second largest in the world, with its financial system having grown correspondingly in size over the years. But there is no reason to expect a Chinese credit crunch to reverberate across the globe with the same vengeance as the collapse of Lehman Brothers.

     For instance, China maintains a current account surplus. In this, its situation is more akin to that of Japan in the late 1980s than to the U.S. in 2008. As a net lender to the rest of the world, domestic financial trouble is unlikely to spill over to other markets to the same extent as if China had borrowed massively from others. Japan's bubble, too, deflated without much pain for the rest of the world. This, of course, is in aggregate. Individual investors, having lent to Chinese firms, would still be exposed.

     It is also true that foreign bank lending to China has increased rapidly in recent years, providing a potential transmission channel to the international financial system in case of local trouble. But again, a robust current account position, along with high foreign exchange reserves, provides a useful buffer by virtually eliminating the risk of a collapse of the exchange rate. This means that the debt service burden of dollar loans will not jump in local currency terms, substantially reducing repayment risk.

     Second, China is a relatively closed economy. Outside of commodities, Chinese demand has not contributed to world growth via increased imports to the extent that headline numbers suggest. This is not to say that many industries would not suffer from a sudden slide in Chinese demand. In Asia, South Korea, Taiwan and Japan would certainly feel the chill of reduced exports of machinery and investment goods to mainland China. But, overall, Chinese growth is far less import intensive than, say, that of the U.S.

     Third, commodities would take a dive. This is perhaps where a sharp slowdown in China would have the biggest impact: For some materials it accounts for 40-50% of global demand. What's more, commodity exporting economies -- including Australia, Latin America and the Persian Gulf, as well as Indonesia and Malaysia regionally -- grew rapidly thanks to improving terms of trade. Falling prices for their exports would thus have a knock-on effect on them as well.

     But there is an offsetting factor: Most of the world consumes, rather than produces, commodities, with falling prices ultimately improving the terms of trade, especially for the larger advanced economies, like the U.S., Europe and Japan. This points to a painful adjustment process, with demand rotating back to commodity importers from exporters. Ultimately, however, falling prices for raw materials would not be an unqualified negative for the world economy.

     It comes down to this: How far down and how quickly might Chinese growth tumble? A sudden jolt would hurt. Even if financial exposure to China remains limited, investor confidence might still take a hit in the short-term, industries relying on mainland demand would see growth derailed, and the benefits of falling commodity prices could be obscured for a while. A gradual slowdown, by contrast, might leave global growth little interrupted. Thankfully, Chinese officials retain powerful tools to steer the process. The hope remains that they will use them judiciously.

Frederic Neumann is co-head of Asian economic research at HSBC.