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China's economy is hitting a wall — and it's going to affect everyone

Mike Bird

(CME Group)
For years, Chinese growth rates have been a byword for extremely fast economic development, and the phrase is still used that way.

Unfortunately for China, the country doesn't actually have "Chinese growth rates" anymore. And pretty much nobody is expecting them to return.

China grew 7.4% last year, missing its own 7.5% target and notching its slowest expansion since 1990. Some analysts think even that is a massive overestimation.

This is unlikely to be a temporary setback — the slowdown is the new normal for the world's second-biggest economy. Within the next decade, China is very likely to be recording growth rates less than half of what it did in the 1980s, 1990s, and 2000s.

That may not seem like such a bad thing. After all, the growth rates that are projected for China are still stronger than pretty much any Western country is expecting for itself.

But there are some compelling reasons for both China and the rest of the world to worry about a Chinese slowdown.

$6.9 trillion in wasted investments

Why does China matter?

China debt/GDP

(Morgan Stanley)
In a word: debt.

China has headed up the emerging-market credit splurge since the 2008 financial crisis. While the recessions in advanced economies threw some cold water over borrowing in the developed world, emerging markets have been racking up debt at quite a speed, with China first among them.

The combination of low inflation and lower growth is a poisonous cocktail as far as paying off debt is concerned. If you borrow on the presumption of, say, 5% inflation and 10% growth in gross domestic product, you have a lot of wiggle room — within five years, your economy (and hopefully your business) will be a lot larger, making your debts look proportionally small.

The inflation chips away at the value of the money you owe, too — a $100 loan principal is worth less after five years of compounded inflation than it was at the time you took it out.

It's worthwhile for developing countries to use public debt when they are industrializing rapidly, but that doesn't mean those bets can't turn sour if the economy doesn't develop as rapidly as anticipated. Chunks of that debt went to poor investments made by profligate local governments: Chinese research indicates as much as $6.9 trillion (£4.39 trillion) was invested wastefully from 2009 to 2014.

The middle-income trap

imf china


A pessimistic take suggests China may be drifting into a scenario that has haunted countries around the world during the past 50 years: a middle-income trap.

A joint IMF-Chinese report published in 2013 notes that very few countries actually escape the middle-income trap. For many countries, making the transition between genuinely impoverished and middle-income seems relatively easy in comparison with catching up to the rich world.

The chart on the right shows how this has worked out for a bunch of middle-income countries:

Most of those that have made it out have, like China, been located in East Asia. But that's not a guarantee of success.

China has made huge efforts to pursue its own path of development, and it is perhaps uniquely reticent about following the models preferred by international institutions such as the World Bank and the International Monetary Fund (IMF).

As a result, the country is part capitalist but with a huge amount of state control. It wants its currency to be of global importance in finance and trade but frets about whether to allow it to float freely on international markets.

We still don't know how this new system copes with shocks exactly, or what the future role of the state will be in Chinese markets. Until recently, implicit backing from the government seemed to be there to prevent Chinese companies from defaulting. But this year there have been major examples of defaults, and the government hasn't stepped in.

The Chinese stock bubble

oxford china

(Oxford Economics)

China is moving massively away from huge investment in property toward huge investment in equities. As a result, Chinese stocks have exploded in the past year, with the main indices more than doubling in value.

That has been driven by an explosion in ordinary retail investors opening accounts. Such investors are unsophisticated and tend to follow market trends in a herd-like manner. People are talking about when, not if, the China stock bubble will collapse.

How Beijing reacts to any collapse in stocks is a big question — but given the relative financial development of China's economy, for now, it's a local question.

The risk of contagion

In 2011, an IMF report named China as the biggest source of real economic spillovers in the world — the trade links between China and the world's other major exporters are now larger than they are for any other region in the world — Beijing leapfrogged Brussels and Washington between 2000 and 2008.

There are still other countries that can shock global economy more — a US banking crash would (and did, in 2008) have a bigger effect, but a Chinese slowdown is no longer some emerging-market crisis that the advanced world can read about in the media and generally shrug off — the impact would be felt around the world.

china spillover king

(IMF, Business Insider)
That's not to say the rest of the world would be thrown into a slump by Chinese growth. The global growth figure in recent years has indeed been fed largely by Chinese growth, so the rate at which the global economy is growing would be brought down. That doesn't mean, however, that growth rates of other specific regions would be largely affected.

Eminent China-watcher Michael Pettis explains what the real problem is for a Chinese growth slowdown:

This means that to assume slower growth in China will reduce growth abroad is wrong. As the growth rate of China's economy drops, the fact that its share of global GDP growth will drop does not presage anything bad for the global economy. What matters is what happens to China's current account surplus. As long as the world suffers from weak global demand, if China's current account surplus declines relative to global GDP, China is adding net demand to a world that needs it. This is positive for global growth. If on the other hand China's current account surplus rises, China will be adding more savings to a world already unable to absorb total savings productively, and the world will be worse off.

The current account is China's financial balance with the rest of the world — how much it exports in goods, services, and income, against the amount it imports. A strong surplus, as Pettis says, would mean China is not a major contributor to global demand, or at least is not a net contributor.

China's failure to break out of the middle-income trap would not affect someone living in the UK or US tomorrow — even most pessimists on China aren't expecting a severe recession.

If the Chinese economy takes a bad path, it will not cause ripples as large as the 2008 crisis. But it will mean an economy of nearly 1.5 billion people is left permanently smaller than it otherwise would have been — probably a much weaker market for Western goods, and a less prosperous world in general.

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