Check mate? Asia’s next move

The latest policy brief from the Asian Development Bank asserts that the continued moderation of growth in the People’s Republic of China could reduce the growth for the rest of developing Asia over the next two years by 0.3%. Bold actions are now needed, it says, from policymakers in the region, such as structural reforms to attract new investment, to counteract the slowdown.

“The gradual slowdown in the PRC economy will continue into the medium term,” says ADB’s chief economist Shang-Jin Wei. “While this will have a negative knock-on effect for many economies in the region, others can also benefit from Chinese households’ increased willingness and ability to consume as well as a shift to a more service-oriented economy in the PRC.”

Weaker demand for commodities from China, meanwhile, will continue to hurt commodity exporters who are already under pressure from a slump in prices, reiterating the need for market diversification. At the same time, the brief noted that while the softer Chinese economy has affected commodity prices, the impact has varied widely across the board.

China’s new normal

A combination of both structural and cyclical factors has resulted in the gradual moderation growth that is currently underway in China, including a shift toward consumption-led growth, partly led by Government, and the natural process of convergence and rising labour costs.

ADB highlights the ongoing shift in economic structure from industry toward services on the supply side, and from investment to consumption on the demand side. A decline in growth contribution from the industry and investment is also underway, but services and consumption growth, while reasonably robust, has not offset the decline.

As industry and investment tend to be more import-intensive than services and consumption, these sectoral shifts suggest that spillovers from the current growth moderation could be larger than in the past, says ADB.

What’s more, the natural process of convergence implies that growth will slow as per capita income rises, and as returns to investment diminish. China has converged quickly over the past 25 years, with its per capital GDP rising ninefold since 1990. As labour costs rose, however, China lost some of its attraction as a base for low-cost manufacturing. Today, wage costs in China are almost four times more than in Bangladesh, Cambodia and Myanmar.

Added to which, weaker than expected demand, due to the lacklustre recovery in advanced economies since the global financial crises, and more recently to weakness in other emerging markets, has been a drag on Chinese exports.

That said, there is a low probability of a sharp drop in Chinese growth in the near to medium term, according to the ADB. Certainly, the Government of China has significant policy buffers in place to respond to adverse shocks and support growth, including plans to expand major rail, road and urban infrastructure projects; reforms to state-owned firms; selective tax reductions; and, increased spending on health and education.

ADB says that the typical decline in GDP growth during a ‘disorderly’ slowdown is around 2%-3%, but with investment accounting for a larger part of GDP in China, a decline in investment and consumption growth similar to past episodes could result in a sharp fall, reducing GDP growth by 4.5%.

While unlikely, a sharp fall in Chinese growth would have a significant effect on all regions, with amplified effects on trade and commodity prices, says ADB. The effects on Asia would be proportionately larger, and an additional negative shock from tightening global financial conditions would contribute to lower growth in the US and Europe.

As it is, the decline in Chinese growth is expected to reduce GDP growth in the rest of developing Asia by 0.3% per year over the next two years, and Japan’s by 0.2%. This reflects China’s strong interregional trade and production linkages. The impact on US and Europe GDP growth will instead be negligible.

Commodity changes

While changes in China’s economic activity undoubtedly affects commodity prices, the share of the commodity price decline attributable to moderate Chinese growth varies across the board. According to ADB, a 1% reduction in Chinese growth lowers the price of coal and metals by 7%-22%, and oil and gas by 5%-7%. These lower prices act as a ‘terms-of-trade’ shock for Asia’s commodity exporters, who are then also hit by reduced export volumes.

The effect on individual Asian economies again varies, and depends on how much they sell to China; how much they sell through China; and how much they compete with China.

Beyond commodity exporters, other economies that export more to China are vulnerable to a slowdown in demand. Those with stronger trade linkages with China experience significantly larger spillovers from changes in Chinese growth. Economies such as Taipei, China; the Republic of Korea; Hong Kong; China; and Malaysia– whose value-added exports to China in both final and intermediate goods and services are relatively high – are more likely to feel the effects of Chinese growth moderation, adds ADB.

New opportunities

But China’s growth moderation and structural shift presents multiple opportunities for developing Asia. Those economies need to tap into the steadily rising demand for goods and services by Chinese consumers, and pursue economic reforms to counteract the effects of the slowdown.

For one, economies that primarily compete with China in outside markets will have the opportunity to increase their own market share as China withdraws. Bangladesh, for example, is already gaining market share as China withdraws from the low-end segment of garment manufacturing; it’s now the world’s second largest garment exporter behind China.

Furthermore, global demand for products China produces in quantity continues to rise but, with China’s labour costs continuing to rise as well, this production is beginning to move to lower cost economies. Vietnam has already become a favoured location for producing mobile phones and consumer electronics, while smaller economies, such as Cambodia and Myanmar, are becoming more attractive investment destinations.

Finally, China’s trading partners can exploit the fact that not all exports will be affected equally. As Chinese consumption remains relatively robust and the growth decline is mostly from investment, economies that export to satisfy Chinese consumer demand, both goods and services, will be better positioned than those catering to Chinese investment demand.