China must manage its slowdown to keep the global economy safe

Low commodity prices are a boon for a resource-hungry economy like India, which needs to import oil, coal and iron ore, among other commodities, to fuel its factory output.  So lower commodity prices is nothing less than a Godsend for India. With oil falling 40% over six months, the country’s oil import bill will decline substantially, adding up to almost 2% of GDP. This may be a natural stimulus and India should relish this moment, but commodity prices have been driven down because of other reasons, which pose equal downside risks for India. 

That China's growth has been slowing is well-known; India is expected to emerge as the fastest growing emerging market in a couple of years, as China's growth declines to 6% levels. But herein lies the risk. China used to grow in double digits and is used to having a balance of payment surplus of 10%. While growth is down to 7%, BoP surplus is down to 2%. 

Under normal circumstances, such a situation would lead to lower capital spending ability, but China has only increased its capital spending and it now is close to 50% of GDP, say economists. Exports growth is also down to single digits from the 20-30% from a few years ago. The massive stimulus of capital spending on unproductive assets has also resulted in marginal return on capital declining sharply. According to HSBC Global Research, it’s not impossible to imagine the development of a vicious circle whereby a lower marginal return leads to unacceptably low growth that triggers more pump-priming, higher levels of debt and an even lower marginal return.

If growth slows dramatically to 4-6 % levels in the next one year, the risk to global markets would be enormous as commodity prices would continue to fall further, besides a decline in trade momentum. This could, in a worst case scenario, lead to a global recession. So long as the Chinese government slows down growth in a gradual manner to undertake micro reforms, the world is safe, but if China's growth slows more sharply than anticipated, it would lead to a selloff in commodity markets and result in sharp volatility in currency markets.