The Eurozone crisis is threatening China’s growth prospects. What is the prognosis for the country’s economy?

At the moment, the news out of Brussels seems positive. The markets are cautiously optimistic that last week’s recent tentative agreement among the Eurozone members toward a new compact on government finance and bank regulation will hold. But investors are holding their breath: a failure could have grim consequences everywhere, including China.

If the Euro crisis continues, the International Monetary Fund (IMF) predicts that growth in China could be chopped in half this year, from 8.5% down to 4%. Nor would the problems end there. According to economists, the effects of continued Western turbulence could be much more far-reaching.

However, most clouds have silver linings. One of the few for China is that European companies would be on sale, making an acquisition more attractive. Even as exports are hit, a weakened or pulverized Euro would put European assets on sale, opening up new merger opportunities for Chinese companies looking to build their global reach.

Richard F.M. Stoffelen, head of the China practice for KPMG Europe LLP in Frankfurt, says that the net effect would likely be slightly positive. “The positive is yes, prices go down, so yes, from that perspective it’s more interesting. The negative effect is uncertainty in the economic environment and uncertainty about the currency in which you own something,” he says.

No Surge in M&A

For now, however, Chinese businesses do not seem to have changed their stance towards European acquisitions substantially. Stoffelen says his phone is still ringing and deals are still being done, but the level of interest has not gone up significantly yet. However, that expectation remains.

Over time, Stoffelen says, he has found that the currency-exchange tends not to matter all that much when both the costs and the revenues of the company are in the same currency. However, when the revenues and the costs are in different currencies, then it can make a bigger difference. For example, he says, for a European Union-focused garment company or oil company, whose raw materials are usually sourced in dollars, the currency differential could be an issue that would require consideration.

But Juzhong Zhuang, deputy chief economist at the Asian Development Bank in the Philippines, argues that although a weaker Euro will hurt China by making its exports less attractive, domestic growth and trade with the fast-growing southern markets could compensate for the shortfall in Western growth. “My view is that growth of domestic demand and South-South trade will offset the impact of weak growth of major industrialized economies to a large extent,” Zhuang says.

China’s South-South trade has been growing strongly in recent years, according to Zhuang. Intra-Asia trade has dominated most of this growth, but Latin America and Africa are also increasingly important. However, their share is still relatively small, he says, less than 20% of the total South-South trade.

More important to Chinese growth right now is its domestic demand, which has continued to rise, and has become especially important since the global financial crisis, Zhuang says. “For instance, in 2011, China’s growth was entirely driven by domestic demand,” he says.

Zhuang argues that these two sources of growth could keep the Chinese economy moving briskly over the next two decades. “I think China has the potential to grow at about 8% annually on average for the period of 2010-2020 and 6% annually during 2020-2030. I am quite optimistic about this prospect,” he says.

Others also remain bullish on the Chinese economy, despite Europe’s problems. Robert Fogel, a Nobel Prize-winning economic historian at the University of Chicago who forecast in 2007 that Chinese GDP would grow to 40% of the world total by 2040, says he remains optimistic today about Chinese prospects. “My opinion that China will continue at a high growth rate for the next 30 years is unchanged,” he said in an email interview with CKGSB Knowledge.

Political Consequences may Dwarf Economic Concerns

Already in Europe, economic trouble seems to be leading to a resurgence of the violent hard right: in Greece, Hungary, the fascists are gaining genuine political power, a matter of concern for China if their xenophobia leads to restrictions on cross-border trade.

Within China, some experts warn the effects on China could go well beyond the consequence of weak sales or M&A bargains. The biggest: a European disaster might slow momentum for domestic economic reform. Jean-Pierre Lehmann, a professor of French and American political economy at IMD in Lausanne, Switzerland, argues that Western weakness could strengthen the hand of Beijing policymakers who argue against reforms that would further expose it to the global economy.

Lehmann, who in addition to his academic work is the founder of the Evian Group, an international coalition of corporate, government, and opinion leaders working toward an equitable and sustainable global economy, says that recent discussions he had with reform-minded policymakers in Beijing suggested that they were worried about the implications a Euro disaster would have on their project.

Worldwide too, the political consequences of a Euro failure might be dire, Lehmann warns: a collapse in the European Union’s most visible project might come to be seen as a proof that supranational governance doesn’t work. If Europe won’t work out an agreement on their currency, how can the entire world possibly reach agreement on climate change or conclude a new global trade agreement? “If you can’t get them to act together in their own enlightened interest, how the hell can you get people to agree on the Doha Round?” Lehmann asks.

Lessons from the Eurozone

On a different note, some scholars say there are also positive economic lessons China may learn from the crisis.

Li Wei, professor of economics and emerging markets finance and Director of the Case Center at the Cheung Kong Graduate School of Business, feels that China can pick some key lessons from the Eurozone crisis to ward off potential threats. The main problem in Europe is not a debt problem – it is about solving internal imbalances, he says. “After joining the Eurozone, the peripheral countries have become too expensive to do business in – their wages have gone way beyond their productivity,” he says. “This structural problem has to be solved.” This internal imbalance is similar to what we are seeing in China today.

“Second, as the country becomes less competitive, the call for government help becomes stronger, and many of the private sector problems get passed on to public sector,” says Li Wei. “Even though China is not a democratic country, it has an overwhelming need to maintain stability and that is draining state funds.”

Rising social costs are themselves a structural cost, Li Wei notes. When income and tax revenues are rising quickly, it doesn’t seem very pragmatic to increase social spending. “But the tide can turn very quickly to make what used to look like a very sustainable debt problem to become intractable. We have seen this in Europe – where a competitiveness problem becomes a sovereign debt problem. And Chinese local governments have large amounts of debt,” says Li Wei. “It is very important to realize that once things go wrong, they can go wrong quickly. It will be a perfect storm.”

Third, he stresses upon the importance to monitor fragility in the financial sector. “In Europe, the collapse of the housing market and the sovereign debt problems are making banks look pretty weak. Many of them are practically bankrupt – they still exist because they are too big to fail. Chinese financial institutions will face similar pressure. So it is very important to make sure that the proper regulations are in place, there is transparency in information,” he warns.

If Li Wei is right, it would suggest that the greatest lesson China can draw from the European experience is that the most daunting political and economic challenges tend to be aggravated when not faced openly. As the example of the Eurozone crisis has shown, the worst kind of deficit of all is a shortage of credibility.