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The Myth of the China Crash
Investors look at screens showing stock market movements at a securities company in Beijing on July 14, 2015. (GREG BAKER/AFP/Getty Images)

The Myth of the China Crash

John Lee

The consequences of a prolonged slowdown in China’s $10 trillion economy will overshadow all else, including an unstable Greece. Or at least that’s a view often expressed in the last few weeks as the Shanghai and Shenzhen stock exchanges melted down.

Yet fears of a contagion effect from China’s slowdown are overblown. For they assume that the country’s enormous economy plays a proportionate role in driving global growth. In reality, the impact of a dramatic and sustained downturn would likely be more psychological than material.

On a superficial level, the belief that a slump in China will affect the rest of the world is understandable. In addition to its economic size and importance as a trading partner to every major economy, China is also the leading manufacturing country by volume. It is hard to believe that an economy that constitutes just less than half of all global growth can sink without creating tsunami-like impacts in every corner of the globe.

But such statistics can be misleading. The Chinese economy is not nearly so important as a driver of global growth.

Take fixed investment, which drives around half of all Chinese economic expansion. Of the up to $4.5 trillion worth of new fixed investment in 2014, less than 3% originated from outside China.

In addition to a still heavily regulated and largely closed capital account, almost every significant sector of the Chinese economy, with the exception of export manufacturing, is designed to privilege state-owned enterprises at the expense of foreign and private-domestic firms. Just as SOEs have been the primary beneficiaries of Beijing’s political economy, they will also be far more exposed to any great slowdown than will multinational firms.

One illustration of this on-the-ground reality: The U.S. firm General Electric, which has targeted Chinese sectors including health care, finance, aviation and energy, recently revealed that it still derives more revenue from a midsize market like Australia than it does from China, despite employing approximately 20,000 people in the latter country.

Then consider China’s often misunderstood role as a trading powerhouse. Export manufacturing is dominated by foreign-owned and foreign-invested firms, which makes China the world’s preferred subcontractor. Any slowdown, or even liquidity crisis, in the Chinese economy is unlikely to significantly effect export-manufacturing operations since the majority of these are financed by foreign capital and is where more than 80% of all foreign direct investment into China ends up.

Even China’s status as a great trading nation is often overplayed. More than two-thirds of China’s trade is in processing trade, with advanced-economy consumption markets in North America, the European Union and even Japan more important as sources of final net demand.

In addition to the restricted access to the Chinese consumer offered to outsiders, some estimate that around 75% of China’s domestic market is made up of nontradable goods. In other words, the net demand China offers the world is significantly less important than the raw size of its economy might suggest. Yet it is increases in final demand that ultimately drive trade, global manufacturing and global growth.

In the 10 years before the global financial crisis, trade between China and the Association of Southeast Asian Nations countries grew at high double-digit rates per year. But when the crisis hit, that trade immediately contracted 7.8%, while GDP growth rates throughout East Asia plummeted. This occurred despite China’s economy, the largest in Asia, growing at almost 9% during that period.

The story is the same when it comes to the excess savings needed by businesses to invest in regional opportunities. It’s true that China consumes too little and saves too much. But most of the country’s savings cannot exit the country. Consequently, Chinese FDI is still dwarfed by U.S., European, Japanese and even South Korean FDI in the region. Neither is China a major source of technology transfers into developing economies around the world. Instead, it absorbs far more foreign technology than it provides to the world.

Or might we be underplaying the possible problem at hand? If the damage from falling stock prices in Chinese exchanges is confined to the tens of millions of speculative investors having to respond to margin calls, then events of the previous week will be remembered merely as a dramatic footnote. But if the share-market panic becomes a contagion that leads to steep falls in the valuation of other assets, such as real estate, Chinese banks and other lending institutions will likely face some trouble, having issued credit using overpriced assets as collateral.

Nonetheless, there is relatively little outside investment in, or in integration with, Chinese banks. This means that aside from those economies reliant on exporting commodities to China, the Chinese people rather than outsiders will bear most of the pain—even if the financial system grinds the economy to a halt. The major external impact is that such developments will finally end the unrealistic expectations the world placed on China to drive global growth

Even if there is no financial or banking-system bust-up, this may be the year China hits the malaise known as the middle-income trap as a result of stalled reforms. This could prove a dangerous period politically for the Communist Party. But judging from the reaction of global markets, the rest of the world has less economic skin in the game than many think.

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