Will China Drag Down World Markets?

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.