How a China Economic Downturn Could Impact the Rest of the World

Across many of the largest economies, consumers are enduring high prices and high interest rates.

While the U.S. Federal Reserve, Bank of Canada, European Central Bank, and Bank of England have been raising interest rates and signaling they will stay high for some time, one central bank cut interest rates in August: The People’s Bank of China lowered its one-year loan prime rate to 3.45%.

There’s good reason. China doesn’t have an overheated economy and thus is charting its own macroeconomic policy path. Policymakers in Beijing are confronted with deflationary pressures, yuan depreciation, and a struggling property sector.

Given the size and wide influence of China’s economy, economists and market observers suggest that these challenges could potentially have broader implications beyond China’s borders, such as:

• A negative effect on global metal exporters.
• New trade partnerships.
• Cheaper goods for developing markets.

Does this mean that now is the time to bet on China? Or does it make sense to bet against the world’s manufacturing hub? We address each of these in some detail.

China’s Impact on Global Commodities Companies

The downturn of the property sector, which used to be a primary economic growth driver, is an example of the impact of China’s campaign to deleverage its economy and reduce its reliance on debt- and investment-led growth. This downturn has had wider-reaching effects, as amid weak Chinese domestic investment and sluggish sales of new homes, commodities-exporting countries that are exposed to China as an end market have taken an immediate hit.

Economists think this environment will continue to depress global commodities demand and commodities prices.

Robert Gilhooly, senior emerging-markets economist at Abrdn, says: “Commodity exporters, such as Chile, Peru, South Africa, and Australia, could see less demand from China. This in turn will lead to cooling global prices, with knock-on effects impacting investment, tax revenues, and broader business sentiment.”

Over the longer term, the deleveraging exercise that is currently underway is an attempt to transition the economy to one that is more consumption-led as opposed to one that is investment-led. Gilhooly explains: “Since investment is relatively import-intensive, China’s shift to endemic living is likely to provide a relatively muted boost to its trading partners.”

In Gilhooly’s view, among major emerging markets, Chile and Peru are particularly dependent on metal and ore exports, and as such they could be more exposed to a further drop in property-related import demand from China.

A China Slowdown Could Reshape Trade Deals

Equally, investors should not forget that the trading pattern isn’t static, and subdued demand from China can be offset by other economies and sectors that are in need of raw materials and commodities inputs.

Chris Kushlis, chief of China and emerging-markets macro strategy at T. Rowe Price, agrees that producers of metals solely tied to housing construction could face pressure from China’s slowing property development. However, a shift toward green energy infrastructure may provide support to metals-intensive exporters in South America, Indonesia, and South Africa.

On the other hand, Kushlis believes China’s offshoring of lower value-added production to frontier markets in Asia has the potential to bolster consumer goods exports from those regions and argues that these changing trade patterns have differential effects across Asia and emerging markets.

Aninda Mitra, head of Asia macro and investment strategy at BNY Mellon Investment Management, monitors the import intensity dynamic between China and its trading partners. “The outlook for Asian exporters increasingly hinges on the global outlook and not just China,” he says. “This is because China’s import intensity—how much it imports per unit of GDP growth—has been slipping for a while now. Falling import intensity has been led by the secular easing of processing trade, the Sino-U.S. trade conflict, and the downturn in China’s property sector.”

Cheaper Chinese Goods Could Help Global Inflation Outlook

Exports to China could be under pressure, but cheaper products are a boon to importers of Chinese manufactures. This holds especially true for economies struck by stubbornly high inflation, which welcome lower prices from the world’s manufacturing hub.

Tiffany Wilding, economist and managing director at Pimco, says: “While disruptions and changes to postpandemic economies have raised questions about the extent to which the Chinese economy still dominates global trade and industrial cycles, we see several reasons to expect spillovers to intensify in developed markets.”

She believes deteriorating Chinese economic fundamentals have produced deflationary pressures that are already moderating inflation both in China and in the global markets served by Chinese goods.

In Wilding’s view, persistent deflation in China would likely spill over to developed markets. “A weaker yuan and elevated inventory-to-sales ratios lower the cost of Chinese goods abroad—a development central bankers in developed markets would likely welcome.”

According to the National Bureau of Statistics of China, the Producer Price Index—which tracks the prices that factories charge wholesalers for products—fell by 4.4% year on year in July 2023 and was down for a tenth consecutive month.

While a declining PPI that is typical of deflationary periods tends to signal an upcoming economic slowdown, Wilding thinks the spillover of falling prices of Chinese products is deemed near-term good news for the Western central banks’ fight against elevated inflation.

She explains: “Despite changing linkages between China and the global economy as Beijing tries to transition to a consumption-led growth model and trade tensions remain elevated with the West, China is still the world’s manufacturer.”

Over the short term, Wilding is observing the usual lags in economic data. “Deflationary spillovers have likely only just begun to impact global consumer markets, with discounting likely to accelerate over the coming quarters,” she says.

Awaiting Stimulus From China

As the backdrop remains deflationary for China, economists think the next catalyst that is pertinent to kick-starting the economy is policy stimulus. BNY Mellon’s Mitra is among the market watchers who worry that China could see a worse year ahead if the right amount of policy support isn’t in place.

“[The property sector] is indeed the biggest driver of the downturn in the Chinese economy,” Mitra says. “It accounts for around one quarter of Chinese GDP and its slump has clearly hurt growth. But the erosion of private-sector confidence has, likely, limited the scope for any offsetting upturn and fueled the deflationary spiral.”

At the time being, Mitra says he’s awaiting “a larger stimulus, which has been hinted at but has not materialized thus far.”

“A prolonged delay in policy support and market reform will likely endanger the outlook for China in 2024 and beyond,” Mitra says.

Whether the risk of more pronounced deflationary pressure could deepen, Pimco’s Wilding adds that adequate fiscal stimulus to boost domestic demand may reaccelerate inflation, while delayed or inadequate policy measures could lead to a downward spiral.

T. Rowe Price’s Kushlis, who looks at the impact on currency and fixed income, believes more stimulus, including additional interest-rate cuts and increased fiscal spending, is needed. Otherwise, the renminbi will continue to face depreciation pressures from the global U.S. dollar strength, given high front-end U.S. yields relative to lower yields in China. This is despite authorities’ efforts to manage the pace of this pressure through a range of active measures in the currency market, he says.

Will There Be a Policy-Driven Rally in China Stocks?

“There’s a downturn, and there’s no denying that,” says Matt Wacher, chief investment officer for Asia-Pacific at Morningstar Investment Management. However, “being an effectively state-controlled economy where the government has a number of leads that they can pull, I don’t think it will go into a Japan-type scenario, even despite the demographic headwinds.”

Wacher continues: “We tend to look through the cycles, so we don’t think that this situation in China is going to last forever. We think that if you look through the cycle some of the valuations particularly in China itself are quite compelling at this point.

“Countries like the U.S., I think that they’re going to be less affected by what goes on in China these days as the U.S. has a much larger economy than both Australia and Brazil, for that matter, a much more diversified economy. ... So, just because it’s not going to be affected as much by a Chinese downturn doesn’t mean that it’s an opportunity, like we don’t think you should go and invest heavily in the U.S. Because we think that there’s valuation risk there, especially in parts of the market that have rallied very hard this year.”

In terms of valuation, Wacher says: “Now is a good time to invest in China, and that’s certainly what we’ve been doing. We don’t have huge positions, but we have reasonably good exposure.”

The aftermath of the anticipated support remains to be seen, says Gary Ng, senior economist for Asia-Pacific thematic research at Natixis Natixis Corporate & Investment Banking. He thinks that investors, especially those betting on a policy-driven stock rally, should keep expectations in check with the accommodative policies, despite signs of the government’s willingness to stabilize growth.

“The market should not be over-optimistic about the size,” Ng says. “It means it is unlikely to see any significant boost to corporate profits and household income. There are more sectors with green shoots, such as electric vehicles, green energy, and tech, but they are not big enough to offset the drag from real estate.”

BNY Mellon’s Mitra told Morningstar that his firm has taken a neutral position on Chinese equities before further policy stimulus from the Chinese authorities is announced and launched. The risk could be capped as the market widely expected such a downturn.

“In this backdrop, it is difficult to foresee how things get much worse unless the growth outlook materially deteriorates from here—say to below 4% year on year, which is not our base case,” he says. “In a similar vein, the price of commodities likely already reflects the weakened state of Chinese fixed-asset investment.”

Mitra continues: “We suggest staying neutral on Chinese equities, which remain too cheap to short and too weak to go long and are likely to provide a hedge against elevated and rising rates in the G3 markets (the U.S., eurozone, and Japan) and recession risks in several pockets of the developed world.