During the past 25 years of relentless growth, China has done well, becoming the world’s second largest economy and boosting its GDP on a purchasing power parity basis tenfold, to 75% of that of the United States.

China has also been a major factor in promoting global prosperity and pushing up the value of U.S. financial assets. Now, however, it is hitting a bump in its growth, dragging down world economies and markets. China’s business model is changing, and investors are asking how those changes will be felt beyond the country’s borders.

In 2006, Niall Ferguson coined the term “Chimerica” to describe a symbiotic economic relationship between the United States and China. Those two economies have been melding together since China began to open up in the 1980s. Bilateral trade grew by a factor of 15 since 1990 and imports from China, at $480 billion last year, comprised 17% of total U.S. imports.

But it’s not only trade volumes that shape Chimerica. America’s trade deficit vis-à-vis China stood at $365 billion last year and averaged around $300 billion over the past decade. In other words, America pumped $3 trillion into the Chinese economy in that time period from its trade imbalance alone. Direct investment by U.S. companies into Chinese manufacturing, chemical, retail and other industries added another $500 billion.

China saved while the U.S. consumed a lot more than it produced. China accumulated dollars and invested them into U.S. financial assets, notably Treasury bonds. Chinese hard currency reserves measure well over $3 trillion and holdings of U.S. Treasuries are to the tune of $1.3 trillion.

Thanks largely to its close business relationship with the U.S., China has grown wealthy and highly industrialized. Disposable personal income of its citizens, which averaged $189 in 1990, has jumped twentyfold and stood at around $3,600 in 2015.

Shared Prosperity

The relationship looks somewhat like the one Spain had with England and Holland in the 16th and 17th centuries, when Spain spent its American gold on imports from those two rapidly developing economies, fueling their growth with transfers of wealth.

However, it is a false parallel, because both China and the U.S. are highly productive economies. Their symbiosis has triggered massive wealth creation in both countries — and in the world economy as well since Chimerica makes up a quarter of the world’s GDP and dominates commercial and financial flows.

For starters, by investing its surplus savings into the U.S. economy, China supported the dollar. In essence, it has been lending money to Americans to keep buying its products. China obviously did so for selfish reasons, to further its own development goals, but in the process it also made America richer.

Plus, the transfer of production to China reduced the prices of goods, resulting in lower consumer price inflation. Inflation in the U.S. was further undercut because high-wage manufacturing jobs disappeared, and wages of remaining jobs came under pressure, hitting demand for goods and services. Lower inflation in turn allowed the U.S. Federal Reserve to keep interest rates low and pump out dollars. Lower costs for U.S. companies, meanwhile, meant higher profits and, therefore, higher stock prices.

Finally, as China spent more money on food and industrial commodities from third countries, those nations too increased their consumption of American goods and services.

To sum up, China has experienced a quarter century’s worth of dramatic productivity growth and an equally massive growth in consumption, the benefits of which were, to various extents, shared with the rest of the world and certainly with the U.S.

All Good Things End

The system worked beautifully but it contained the seeds of its own destruction — on both shores of the Pacific. The Great Recession of 2008–09 was the first major alarm bell. Easy dollars created asset price bubbles, the largest of which occurred in residential real estate; Americans increasingly used their properties as personal ATM machines, withdrawing accumulated equity to make up for stagnant wages.

Even though the real estate bubble burst calamitously in 2008, and financial catastrophe was only narrowly avoided, the Chimerica economic model did not change. The crisis, engendered by plentiful liquidity at historically low rates, was remedied by even more liquidity at even lower rates — actually, with free money and, now, even with negative interest rates.

China avoided a severe crisis by providing massive domestic stimulus even as its export-led growth model started to sputter. The kind of manufacturing China has been betting on was always a race for the bottom, since the country produced goods that competed on price and could be undercut by others who produced cheaper. After 2008, China experienced rapid wage growth. Costs of production also rose — including externalities and social costs associated with massive pollution: China now faces long-term health care and cleanup costs, among other expenses.

Even though it has been depreciating its currency, the yuan, since late 2013, China no longer can profitably sell its key resource, cheap labor. Production is moving to lower-cost regions including Indochina and Africa. At the same time, more and more labor-intensive tasks are being automated and production is returning to rich countries — minus the manufacturing jobs that departed two decades ago.

Forcing the Fed

China’s growth has slowed and some of the benefits felt by the world economy over the past two and a half decades are starting to go in reverse. The commodities bubble has deflated, and the dramatic drop in world oil prices has been a major factor driving deflationary pressures worldwide. The Chinese stock market tumbled by some 25% since September, and its decline has been felt around the world, destabilizing other stock markets including Wall Street.

Ironically, the Fed’s decision to raise its interest rates owes much to slowing economic growth and falling investment in China. How? Last year, China set a record with $550 billion in capital outflows. Much of that money found its way into the U.S. economy, its frothy real estate markets in New York, Miami and elsewhere and to Wall Street — since the U.S. has been the one bright spot in an otherwise gloomy global economic picture.

This money exacerbates already considerable imbalances in the U.S. economy and financial markets. There has been a burst of economic growth and a hiring boom, as 2.5 million new jobs were created in 2015, such that the Fed has been compelled to act.

Beijing leaders are aware that the country’s development model has been played out and have been looking for different sources of growth since the new leadership team assumed office in 2012. They aim to replace export-led growth with domestic consumption, substituting services for manufacturing. The Caixin purchasing managers’ index of manufacturing has been below the 50 mark separating growth from contraction since March 2015, whereas the same index in services remains steadily above 50 and moved sharply higher in January.

Western political analysts and economists have been highly respectful of China’s leadership. The Chinese government has presided over remarkable growth and social change in the world’s largest country, avoiding both economic downturns and political upheavals. The view has emerged that it has got it all figured out. At a recent public talk in New York City, former U.S. Defense Secretary Robert Gates repeated the cliché that the Chinese think in terms of centuries — in contrast to Western planners who often don’t have a horizon extending past the next elections.

But claims of Chinese Communists’ omniscience are highly overstated. It is the same party of Mao Zedong that engineered famines that killed millions and kept China as poor, underdeveloped and isolated as North Korea. During the Cultural Revolution, educated people were persecuted and a generation of Chinese was deprived of education. China would have remained backward had it not been for Deng Xiaoping winning the post-Mao power struggle. Current leaders are certainly more capable than their predecessors, but they are also more corrupt. In any case, their success in a highly risky transition is by no means assured.

Japan’s Example

In fact, China looks more likely to go the way of Japan — which also used to be seen as a ruthless, calculating power bent on world domination. Indeed, the Chinese have so far pursued a similar path of export-led development, working hard for lower wages and battling a reputation for shoddy products.

China’s demographic problems are not unlike those of Japan. According to projections by the United Nations, China’s population has already peaked and by the end of the century will drop by 300 million. Just as in Japan, the population is rapidly aging; moreover, China lacks adequate state pensions and its problems are exacerbated by the effects of a one-child policy.

China’s one-party system takes to a greater extreme the one-party dominance of Japan’s politics. Other similarities abound. Like Japan, China has experienced overinvestment in infrastructure; much like the Japanese, the Chinese are huge savers; and, exactly like Japan, China has experienced real estate and stock market bubbles.

Chinese companies are using their cash hoard to acquire Western companies. There is no guarantee that they will be more successful at running them than the Japanese were in an earlier era, when they went on a shopping spree for New York real estate and Hollywood studios only to discover that they had vastly overpaid for them.

Capital flight from China and rising interest rates in the U.S. signal the end of the Chimerica model. Even if China is successful and revamps its enormous economy, refocusing on domestic consumption and ushering in another period of breakneck growth and prosperity, its transition will cause major near-term disruptions in the world economy and financial markets.