How Would China's Slowdown Affect the Global Economy?

How to Protect Your Portfolio Against Potential Declines

Neon signs on Nanjing street in Shanghai at night.
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China has the world’s fastest growing major economy with growth rates averaging 10% over the past 30 years, according to the International Monetary Fund (IMF). As of the end of 2017, the country’s economy was the second largest in the world by nominal gross domestic product (GDP) and the world's largest by purchasing power parity (PPP) next to the United States, driven largely by its manufacturing sector that exports goods that are widely consumed around the world.

Potential Drivers Behind a Slowdown

Many economists believe that China’s economy will begin to slowdown as its population ages and wages rise to meet global standards. In the past, the country benefited from strong growth in its working-age population along with relatively low wages that fueled its manufacturing sector. The problem is that these changes occurred at the expense of its service sector and manufacturing has required less and less labor over time as technology has replaced jobs.

Ultimately, many economists believe the country will have to migrate from manufacturing to services as a primary driver of GDP, just as other developed countries like the United States and those in Europe have done in the past. More moderate balanced growth of less than eight percent could raise employment, wages and private consumption more quickly than unbalanced growth greater than eight percent. In 2015 and 2016, the government has explicitly embraced this transition to services.

Implications on the Global Economy

China’s economic slowdown would impact different regions of the world in different ways depending on their exposure. In countries dependent on commodity exports, like Australia, Brazil, Canada, and Indonesia, the slowdown could have a negative impact on their GDP growth as demand slows.

The inevitable fall in commodity prices could be beneficial, however, for other countries that consume the commodities, such as the United States and countries across Europe.

Either way, the slowdown will require some adjustment on the part of the global economy. The country has been the single largest contributor to global economic growth over the past several years, according to the IMF, contributing 31 percent on average between 2010 and 2013. These figures are significantly higher than its eight percent contribution in the 1980s, but some economists argue that the U.S. and Europe could pick up much of the slack as the global economy rebounds from the 2008 financial crisis.

Positioning Portfolios for a Slowdown

International investors can brace against some of the implication of a slowdown in China’s economy by taking simple measures aimed to rebalancing their portfolio to account for these changes.

Some potential steps to take include:

  • Reduce Commodity Exposure. The most profound effects of a slowdown in China’s economy would be reduced consumption of commodities, and as a result, lower commodity prices over the long-term. However, it's worth noting that commodity futures trade based on expectations rather than reality, so the timing of these declines will depend on perception. It's also possible that other countries will pick up the slack, particularly those in Southeast Asia.
  • Increase Diversification. Investors can mitigate the effects of a decline in any individual country by ensuring that their portfolio is properly diversified in countries around the world, including developed countries like the U.S. and regions like Europe, as well as in other emerging markets that could be positioned to takeover manufacturing activity.
  • Hedge with Puts on Chinese ETFs. Investors can purchase long-term put options on Chinese ETFs or short-sell Chinese stocks in order to hedge their portfolios, profit from their declines, and offset any long Chinese positions in their portfolio. The downside is that these active strategies require a certain level of market timing that can be difficult to pull off, which makes them the last appealing of these options.

Investors should also be cognizant of the potential for a sharp contraction in China.

Like other economies, China could experience a boom-bust cycle that could damage its equity and bond markets. The real estate market has become a major concern in 2016 and 2017, but other asset bubbles could become equally oversized if the economy overheats and regulators aren't able to rein in growth. These are important trends that investors should keep a close eye on over time.