During the past two months, investors have become more concerned about global growth in the wake of weaker trade data and softer Purchasing Managers Indexes. These recent trends show that a deficiency of demand continues to weigh on global growth, keeping the recovery bumpy, brittle and below par. At the heart of the global slowdown is the sharp deterioration in emerging market (EM) domestic demand due to slower growth in China, a stronger US dollar, tightening of financial conditions and payback from past misallocation. Developed-market (DM) domestic demand, by contrast, has held up relatively well. The divergence shows up in real import-growth trends (see chart).

With EM growth having weakened to a six-year low in the second quarter of 2015, investors are debating whether China—a key anchor in the emerging markets—will continue to decelerate. They are also pondering whether there is a risk for a systemic crisis similar to 1997 and 1998. We view both of these scenarios as unlikely.

To assess the underlying growth in China’s tradable sector—the one that matters for the rest of the world—we look at our propriety measure, MS-CHEX, which is driven by industry and reflected in China’s nonoil imports. This part of the Chinese economy had already slowed significantly between late 2014 and March 2015 and has flattened out since then. However, a combination of a sharp fall in China’s A shares between June and July and then a 1.8% depreciation move on Aug. 11 prompted new investor concerns regarding an adverse impact arising from the stock market fall, as well as potential capital outflows that could cause policymakers to tolerate a large currency depreciation. In terms of the economic fundamentals, we have been concerned about low returns on the incremental capital employed, large excess capacities, persistent disinflationary pressures and debt-management challenges.

That said, we do not see large capital outflows causing a sharp fall in the currency, a spike in the cost of capital or a shock to the banking system. Instead, we believe China’s policymakers will be able to stabilize currency expectations, steer monetary conditions and prevent a further sharp deceleration in growth. In our view, they have three key tools at hand: a reasonably sized and rising current account surplus, which provides natural support against capital outflows; a large positive net international investment position, which enables them to offset outflows by running down foreign currency reserves; and low Consumer Price Index inflation and outright Producer Price Index

Indeed, we believe China’ policymakers will be successful in stabilizing industrial activity at low levels with their recent accelerated pace of policy easing.

On the monetary policy front, policymakers have already cut policy rates three times within five months (a cumulative 165 basis points in this cycle) and in August and October lowered the required reserve ratio by 50 basis points (a cumulative 200 basis points in this cycle). These measures have helped keep M2 money-supply growth stable at around 13% and overnight interest rates below 2%, despite recent capital outflows. More crucially, real rates have eased at the margin, though the impact has been felt more by the household sector, which is lending support to property transactions. On the fiscal front, policymakers have also picked up the pace of spending, lifting the fiscal deficit to 3.0% of GDP in September, from 1.9% of GDP seven months ago. In addition, policymakers are working on lifting spending by local governments, with the debt-swap program helping to lower their funding costs. What’s more, they have lowered the sales tax for auto sales and also relaxed the down payment for property purchases. Moreover, we expect policymakers to embark on more easing measures as they seek to prevent a sharper slowdown. As a result, we expect the recent easing measures to filter through to an improvement in growth.

Will the emerging markets ex China face a serious drag on growth? Slower growth in China, weaker commodity prices and a more flexible People’s Bank of China (PBOC), which now targets a stable trade-weighted exchange rate, have caused fresh concerns about the EM economies. These concerns also include potential systemic risks that could emanate as they did in 1997 and 1998. We believe that scenario—an abrupt, systemic EM shock, translating into a deep banking-system crisis in which adjustment is forced at a rapid pace—is not likely. Persistent disinflationary pressures, current-account surpluses, flexible exchange rates and adequate foreign-currency reserves give policymakers in large parts of the emerging markets better control over liquidity conditions and the cost of capital, which will allow policymakers to make adjustments in a gradual manner.

While DM growth has been holding up better than EM growth, it has been affected by weaker EM growth and weaker EM currencies. G3 exports to the emerging markets have been declining since January and net trade has been a drag on US growth for most of the year, subtracting a full percentage point from headline GDP in the third quarter alone. In Japan, a poor run of industrial-production data over the summer implies that a negative third-quarter GDP report can no longer be ruled out. At the same time, domestic demand in the US is stronger than expected, notably consumer spending, and overall economic activity in the Euro Zone remains resilient.

Looking ahead, investors are debating whether the developed markets could be dragged down by the emerging markets and whether another leg down in the emerging markets will tip the global economy into a recession, just like developed markets did in 2008. However, back in 2008, the global financial crisis caused many emerging markets to lose control of their cost of capital. This sharp rise in the cost of capital materially weighed on domestic demand. Coupled with the drag on trade from the developed markets, this pushed many EM economies and the global economy into recession. At the present juncture, we do not expect the developed markets to recouple fully with the emerging markets (see page 4). What’s more, DM central banks, courtesy of their reserve-currency status, are likely to retain control over their cost of capital, and they have also taken note of recent global economic developments—specifically weakness in EM growth. Policymakers have indicated that they stand ready to adjust their monetary policy to mitigate the potential impact of such weakness on domestic demand and the underlying inflation outlook.

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