Over the past several months, investors and consumers have been rattled by worrisome financial headlines. This includes a barrage of bad news coming out of China—stock market volatility, slowing investment, contraction in the construction market, stagnant profits, a desperate currency devaluation in August, and apparently incoherent government policy interventions—which have produced "headline effects" that have led to gyrations in global equity markets.

Fortunately, the international "contagion" from these events has been limited. China's domestic stock market is relatively closed, and its recent equity bubble was largely financed with local money, rather than by foreign banks; these factors helped to insulate it from the rest of the world. In addition, the Chinese stock market has relatively weak linkages to consumer and business spending, so those areas are not being seriously affected. The stock market plunge therefore had limited implications for China's real gross domestic product (GDP) growth.

Article Figures

[Figure 1] China's economic growth will downshift in the long run Enlarge this image

[Figure 2] The services sector now dominates China's economy Enlarge this image

Nevertheless, China is in the midst of a slow and painful transformation from a global production powerhouse to a more middle-class-dominated, service-oriented economy. The nature of this transformation is having an important impact on supply chain dynamics and international trade patterns.

The short-term outlook
There is no question that the Chinese economy is experiencing a rough patch. Although the country's GDP was not seriously affected by the stock market rout, there are signs that Chinese investors' confidence has been shaken. For example, anecdotal evidence suggests that very high-end luxury outlets in Shanghai and Beijing are seeing fewer customers.

As shown in Figure 1, China's GDP growth has moderated in each of the last four years. This slowdown is likely to continue—but not because of the recent stock market volatility. Rather, we are seeing the continuation of a downturn that is most evident in mining, heavy manufacturing, and utilities, while services and light manufacturing are proving more resilient.

Policy adjustments regarding China's exchange rate will lead to more financial market volatility, but this is unlikely to signify the start of a transition to a "weak renminbi" policy, and China is unlikely to devaluate its currency much further. The biggest threat to China's growth prospects is not short-term economic and financial fluctuations, but rather the country's vast excess industrial capacity, which had been financed by an explosion of debt.

China's economic growth should settle near 6.5 percent over the next few years as fixed-investment gains subside. This is significantly below the double-digit growth rates of the 2000s as well as the 7.3 to 7.7 percent quarterly growth rates seen between 2012 and 2014. Moreover, China's contribution to global gross domestic product growth approached 45 percent in 2008 but is currently standing at less than 30 percent.

The underlying issue, as most China watchers and business analysts recognize, is that the Chinese economy is transitioning from an agricultural and industrial-centric powerhouse to a more consumer- and service-oriented economy.

China's service-industrial divide
A very important trend has been underway for some time in China: the secondary sector (industry and construction) is losing ground to the service sector. In 2012, the secondary sector accounted for 45 percent of the country's GDP, the first time since 1978 that industry and construction were not the largest source of economic growth. This decline relative to the service sector is due to two main reasons:

1. Nominal growth in the secondary sector became less consistently positive during the period 2007-2011, due in part to volatility in domestic investment trends and global commodity prices that were associated with the global financial crisis. As a result, the secondary sector's share of total output fell by an annual average of 0.3 percentage points during that period.
2. China's service sector has enjoyed steady increases in its share of total output throughout most of the period since China's reform and opening to international trade in 1978. Before then, under a planned economy, industry had been excessively favored, and thus even gradual market liberalization provided plenty of room for catch-up growth. During the 1990s and 2000s, China's service sector increased its share of output by about one-half percentage point per year. Together, industry and services gained share during this period—not necessarily at each other's expense, but rather at the expense of agriculture, which declined in importance.

These two factors resulted in the industrial sector losing its top spot as a source of output in 2012. Between 2012 and 2015, industry lost an average of 1.4 percentage points per year in its share of total output, while services gained over 2 percentage points per year. By the first half of 2015, services accounted for 52.5 percent of China's nominal output, while industry's share had fallen to 40.7 percent (see Figure 2).

Employment data corroborate this trend; both industrial and service-sector employment rose steadily as a share of the total between the late 1990s and late 2000s, but in most recent years, particularly from 2007 through 2011, services employment continued to rise in relative importance while industry accelerated and then stagnated.

The international effect
This transformation is likely to have a profound impact on supply chain dynamics and international trade patterns. The slowdown in investment in residential, office, and industrial construction means that the vast flow of material commodities from Australia, Brazil, Canada, Indonesia, and Sub-Saharan Africa that was feeding the Chinese construction boom is not likely to return in the near future.

The strong growth of Chinese imports of raw materials and capital equipment that fueled the massive increase in industrial output seen over the last several decades is likely to be edged out by the importation of lighter, high-precision capital equipment for the higher-value-added light manufacturing and service sectors. Economies and industries that have significant exposure to the Chinese construction and heavy manufacturing sectors are therefore looking at increasing downside risks to their economic outlook. The silver lining is that the Chinese appetite for lighter and higher-precision capital equipment is likely to remain strong for many years, in spite of the turbulence the economy may face. In addition, since consumer spending is expected to play a stronger role in the economy, the importation of consumer goods and certain foods products is likely to increase.