Changyong RheeBy Changyong Rhee

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From advanced economy financial markets to developing country commodity producers, the world has closely followed developments in China in recent months. After 35 years of extraordinarily rapid growth, the Chinese economy is undergoing a major transition from export-led growth to a model increasingly driven by consumption and services, with less emphasis on debt-financed public investment.

This process has been accompanied by a slowdown in imports and financial market volatility, raising reasonable concerns about the impact on the global economy, and particularly the spillovers to countries that have benefited most from China’s rapid rise.

It is important to understand, however, that the transition is essential if China is to create a more inclusive economy that gives greater play to market forces and achieves safer and more sustainable growth. This will involve a delicate balancing act for the Chinese government—implementing reforms while maintaining demand and financial stability. As reforms proceed, it will be critical to ensure effective governance of newly liberalized markets and enterprises. This will require, in particular, hardened budget constraints for both state-owned and private firms, and continued strengthening of the financial supervision framework.

So far, developments in the real economy provide some comfort that the transition can be managed. The current pace of China’s slowdown remains in line with the IMF’s forecast (and that of the authorities themselves), although downside risks have increased. This is based on the strength of infrastructure investment and consumption—particularly in services—even as activity has clearly weakened in manufacturing and construction.

China has adequate policy space should further policy stimulus become necessary to prevent growth from falling excessively. The focus of such measures should target both demand and rebalancing (for example, by providing support for consumption, especially by the more vulnerable members of Chinese society).

By contrast, it would be preferable to avoid the renewed use of debt-financed investment so as to prevent a resurgence of corporate leveraging. Since the Global Financial Crisis, growth in China has relied heavily on investment and credit, with the biggest buildup of leverage going to state-owned enterprises, the real estate and construction sectors, and weaker corporates. This created growing vulnerabilities which—while still manageable—cannot continue to accumulate.

The dangers of excessive leverage have become clear in the stock market. Fueled by strong credit growth, which has since slowed down, stock markets surged by over 100 percent between November 2014 and this past June—only to correct by 40 percent in recent months. This correction was probably necessary, but it had significant global spillovers. The good news is that it is expected to have only a limited direct impact on the economy, given the low degree of share ownership by Chinese households and the low share of equity in corporate financing.

The recent change in the exchange rate regime also had large ripple effects, particularly in Asia due to the uncertainty created by the move. However, the change in the exchange regime is consistent with the authorities’ intention to move to a more market-determined exchange rate. Moreover, following a significant real appreciation over the past year, the renminbi has only depreciated by around 3 percent since the change. This does not alter the IMF’s assessment that the exchange rate is broadly in line with medium-term fundamentals.

While China’s economy slows as expected, the country’s size and integration into the global economy mean that its performance affects those around it. We have estimated that a one percentage point slowdown in Chinese growth translates into a 0.3 percentage point decline for other Asian countries. Such spillovers obviously are of concern, and recent experience suggests that spillovers to China’s neighbors in Asia might have become even larger lately, coming not only through trade but also global financial market linkages.

Spillovers have been magnified by forces that extend beyond China’s border—including falling commodity prices and the prospect of an increase in U.S. interest rates—which could produce downward pressure on Asian neighbors.

The bottom line is: vigilance must remain the watchword. For China, that means focusing on the downside risks, and for the rest of the world, guarding against potential spillovers. If managed well—including with clearer communication to help guide market expectations—China’s transition could provide the basis for renewed economic strength in a region that has led the world in growth for several years.