China may tip world into recession, Morgan Stanley's Sharma says

Forget about all the shoes, toys and other exports. China may soon have another thing to offer the world: a recession.

That is the prediction from Ruchir Sharma, head of emerging markets at Morgan Stanley Investment Management, who says a continuation of China’s slowdown in the next years may drag global economic growth below 2 percent, a threshold he views as equivalent to a world recession. It would be the first global slump over the past 50 year without the U.S. contracting.

“The next global recession will be made by China,” Sharma, who manages more than $25 billion, said in an interview at Bloomberg’s headquarters in New York. “Over the next couple of years, China is likely to be the biggest source of vulnerability for the global economy.”

While China’s growth is slowing, the country’s influence has increased as it became the world’s second-largest economy. China accounted for 38 percent of the global growth last year, up from 23 percent in 2010, according to Morgan Stanley. It’s the world’s largest importer of copper, aluminum and cotton, and the biggest trading partner for countries from Brazil to South Africa.

The International Monetary Fund last week cut its forecast for global growth this year to 3.3 percent, down from an estimate of 3.5 percent in April, citing weakness in the U.S. While the Washington-based lender left its projection on China unchanged at 6.8 percent, the slowest since 1990, it said “greater difficulties” in the country’s transition to a new growth model poses a risk to the global recovery.

Fund performance

China’s economy will continue slowing as the country struggles to reduce its debt, Sharma said. An additional 2 percentage-point slowdown would be enough to tip the world into a recession, he said.

The global expansion, measured by market exchange rates, has slipped below 2 percent during five different periods over the past 50 years, most recently in 2008-09. All the previous world recessions have coincided with contractions in the U.S. economy.

Sharma’s $1 billion U.S.-traded Emerging Markets Portfolio has returned 2.71 percent annually over the past five years, outpacing gains in MSCI Inc.’s developing-nation benchmark, according to data compiled by Bloomberg.

Sharma said he’s shunning Chinese stocks and those in countries that rely on China for growth, including Brazil, Russia and South Korea. He favors companies in eastern Europe and smaller Asian countries, such as the Philippines, Vietnam and Pakistan.

Volatile market

China’s $6.8 trillion equity market roiled global investors over the last few weeks after a yearlong rally accompanied by record borrowing and surging valuations ended in a bear market.

The Shanghai Composite Index slumped more than 30 percent in four weeks through June 8, wiping almost $4 trillion in market value. The unprecedented government intervention used to bolster the market failed to inspire confidence until last week when regulators banned major shareholders from selling shares for six months and allowed more than half of listed firms to suspend trading.

The market collapse has challenged some investors’ long- held conviction that the Chinese authorities have an adequate grip on the economy and markets and that the government is always able to achieve its goals, said Sharma.

“What happened in China last week was so significant in that for the first time, you’ve got this sign that something is out of control,” Sharma said. “Confidence damage is going to last for a while.”