China Exports Trouble, Too

China, the so-called factory of the world, has just produced its newest product—a global stock-market correction. The 9 percent plunge in the Chinese stock market late last month was a shot heard around the world. The hows and whys of this contagion speak volumes to the new and important role China now plays in driving the global economy and shaping trends in world financial markets.

There are three key pieces to this puzzle—the first being China's disproportionate impact on the global economy. While a $2.6 trillion Chinese economy amounts to only about 5 percent of overall world output, it makes up a much larger share of the growth in the global economy. In 2006, for example, China's surging economy accounted for about one third the total increase in world GDP. Moreover, during the past four years, China has been responsible for about 50 percent of the cumulative growth in economically sensitive commodities such as oil and a variety of base metals, like aluminum, copper, lead, nickel, steel, tin and zinc. And, as the world's largest saver with the biggest current account surplus, China has played a major role in injecting investable funds into financial markets already awash in excess liquidity.

Second, the Chinese leadership is now signaling that it is determined to slow its economy. That was the central message of Prime Minister Wen Jiabao's annual "Work Report of the Government," delivered at the opening of the National People's Congress on March 5, in which he underscored a targeted slowdown of Chinese GDP growth from 10.7 percent in 2006 to 8 percent in 2007. The prime minister stressed the need for China to rebalance its economy—moving from overreliance on the high-growth sectors of exports and fixed investment toward increased emphasis on a slower-growing and more sustainable consumer-led economy. This message was foreshadowed in the week ahead of the prime minister's pronouncements, when Chinese authorities moved to temper its equity bubble by encouraging state-directed sales of stocks as well as further restricting bank lending.

There can be no mistaking the global implications of the coming China slowdown. If, in fact, China hits the 8 percent growth target announced by Wen, this would represent a 25 percent deceleration from the heady pace of 2006. Adding in China's cross-border trade linkages to neighboring Asian economies, along with impacts on a resource supply chain that stretches from Australia and Canada to Brazil and Africa, the overall effects of a China slowdown could easily knock more than 0.5 percentage points off global economic growth in 2007.

There is a third consideration at work as well—China's role as a bellwether for emerging market securities. Long known for being among the riskiest of assets, stock and bond markets in the developing world have enjoyed an exceptionally vigorous rally for the past several years. More recently, China has led the pack, with an outright doubling of its stock market from August 2006 through mid-February 2007. The 9 percent decline in Chinese equities on Feb. 27 was a wake-up call—reminding investors that it is foolish to ignore risk in risky assets. Cascading effects into other developing markets reinforce the important financial-market conclusion that a broad outbreak of risk aversion can also be made in China.

The message from Beijing is that there could well be more to come on the China slowdown front. Yet financial markets are suspicious of China's willingness to pull it off. And with good reason—this is the third year in a row when growth has remained exceptionally rapid in the midst of an on-again, off-again tightening campaign. Yet I suspect this is the year to take the warning more seriously. China's imbalances—excessive growth in bank lending, a stock-market bubble and increasingly irrational spending on new manufacturing capacity—now pose an increasingly serious threat to economic stability. In China, nothing matters more than stability. The case for further action is compelling.

The good news is that Chinese leaders are meeting this challenge head-on. By moving quickly, the coming China slowdown will stop well short of the dreaded hard landing. This may be bad news for world financial markets, however. Investors counting on open-ended growth in the Chinese economy could be sorely disappointed.

Of course, there is more than the "China factor" to consider in framing the global growth debate. Equally important are the ever-mounting reverberations of America's post-housing bubble shakeout. The combination of a Chinese and a U.S. slowdown would undoubtedly make the shortfall in global economic growth even more acute. That's the last thing increasingly complacent investors were looking for—reason enough to believe that there could well be more to come from the world's first financial market correction made in China.