What China's Economic Slowdown Means for the Rest of the World

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An Iranian staff member works at the South Pars gas field at the port city of Assalouyeh, Iran on November 19, 2015. The South Pars field is a natural gas condensate field located in the Persian Gulf, one of the world's largest, shared between Iran and Qatar. Though the lifting of international sanctions against Iran held high hopes for its domestic oil prices, the decreased cost of a barrel of oil—affected by its neighbor Saudi Arabia's influence on oil supply and market prices—may draw lower profits than expected, upending economic forecasts for Iran's oil sales and the global economy at large. Ahmad Halabisaz/Xinhua/eyevine/Redux

History doesn't repeat itself, Mark Twain supposedly once said, but it sure does rhyme sometimes. In 1997, once vibrant emerging markets in Asia began toppling one by one. Currencies cracked. International credit markets came under intense pressure. Oil prices plunged as the Asian financial crisis spread to Russia—which defaulted on its debt—and other parts of the former Soviet Union. Through it all, the largest economy in the world, the United States, sailed on almost unperturbed. Its gross domestic product continued to increase at a rate that many economists now believe is unattainable—more than 4 percent per year—even as growth slowed in the developed economies of Western Europe.

Nearly two decades later, with China sending shockwaves through global stock markets, the tune sounds familiar. But it's important to pay attention not to the similarities between then and now but to the differences. First and most obvious, as Ruchir Sharma, head of emerging markets and global macro strategy at Morgan Stanley, pointed out in a January 13 essay in The Wall Street Journal, is the share of global GDP that China now claims and the country's role in driving markets worldwide. Beijing has become the second biggest economy on the planet and has been for several years now the largest contributor to global economic growth.

Beijing's period of supercharged advancement is now over, as anyone in the business of selling oil, copper or any other commodity could have told you for at least the past year. The stunning drop in global commodity prices has been driven not only by the marked slowdown in China's overall growth but also in the composition of that growth. The massive build-out over the past decade of both infrastructure and residential real estate is no longer the catalyst for China's economy.

China's hyper-growth phase—and in particular the period after the 2008 financial crisis, from which it emerged without an apparent scratch—gave its economic planners a reputation for extreme competence. They seemed to know all the right policy levers to pull. New York Times columnist Thomas Friedman made the controversial argument that it might be good to be "China for a day." As a citizen of the inefficient, messy democracy that is the United States, he pined for the authoritarian wisdom emanating from Beijing.

To a large extent, the exalted reputation was undeserved. Prior to the crisis, the economic path China trod was well-worn: an export- and investment-led strategy that Japan, South Korea and Taiwan (among others) had implemented in the past. Then, post-crisis, China simply threw money at the economy—and piled up huge debts that are now coming due.

These thoughts—that China is slowing more rapidly than we thought and isn't as smart as we believed—have now gripped global financial markets. Beijing's ham-handed response to two successive stock market swoons—one last summer and the latest just as the new year began—has been unsettling. In the most recent episode, Beijing insisted on allowing so-called circuit breakers to halt trading on two separate trading days, only to come to the understanding that the halts increased investor panic. The circuit breakers are now gone.

In theory, markets in the outside world shouldn't react as violently as they now do to what happens in China's equity markets. Chinese stock markets are not widely tradable abroad, and they do not tell investors much about the health of the Chinese economy in the way markets do in the developed world. China's two main bourses still tend to be traders' markets driven by rumors and guesses as to what the government wants the market or the economy to do, as opposed to investors' markets driven by fundamental economics. But Beijing's unsteady policy hand has freaked out investors—and will continue to do so. "The combination of inexperience, inappropriate guidance and an instinct to intervene based on unwillingness or inability to accept volatility is potentially very damaging," says Michael Pettis, a professor of finance at Beijing's Peking University. "It can only increase volatility in all financial markets, [and] there is no reason to assume that anything will change for the better during 2016."

Another factor conjuring memories of the 1997 Asian crisis is the management of China's currency, the renminbi. China has allowed it to weaken slightly against the U.S. dollar in recent months, after a prolonged period of relative stability. As Pettis wrote recently, this has increased fears globally that other countries will devalue their currencies to keep up with each other on exports, a move that would be hugely destabilizing. With the Mexican peso, the most widely traded emerging market currency, already under pressure, Mexico's finance minister, Luis Videgaray, said, "There is real concern that the public policy response [to China's economic weakness] will be to start a round of competitive devaluations" in an effort to boost exports.

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Workers walk along the construction site of a metro line in the China (Guangdong) Pilot Free Trade Zone in Shenzhen, China on July 16, 2015. Once a catalyst for Chinese economic growth, real estate development and infrastructure projects are no longer its main driver, slowing the Chinese economy in tandem with a drop in global commodity prices. Liu Dawei/Xinhua/eyevine/Redux

This may be unfair. China has moved, with the approval of the International Monetary Fund, to align its currency not with the U.S. dollar but rather with a basket of currencies. This as much as anything accounts for the renminbi's recent weakness against the dollar. And in the past two months, far from guiding the renminbi lower, the government has been intervening to prevent what might be a much sharper, market-led sell-off against the dollar, as even more capital flows out of China as the economy weakens. (In the last quarter of 2015, investors took $367 billion out of the country, an amount, as Bloomberg reported, greater than Greece's GDP.) Expect that policy to continue.

Many emerging market currencies are under pressure—just as they were nearly 20 years ago—but the reason this time is different. Currencies in Mexico, Russia, Nigeria, Kazakhstan and Azerbaijan, to name a few, have all plunged—some to record lows—against the dollar in recent weeks. What do they have in common? They are all countries whose economies depend heavily on oil exports. They are casualties in what has been for more than a year now an economic war between Saudi Arabia—the world's largest oil exporter—and its geopolitical archenemy, Iran, a major oil producer now looking forward to the removal of sanctions, which will enable it to export more oil legally. The result of this war has been an oil price decline that has surprised most analysts but has not reached its low.

Saudi Arabia—with a largely Sunni Muslim population—is in the midst of an intensifying proxy war against Shiite Iran as the two vie for regional hegemony. That war is taking place in Syria, in Yemen, in Iraq—and in the global crude oil market. The economically rational thing to do for Saudi Arabia, the lowest-cost oil producer in the world, has been to cut production to support prices as demand from China and elsewhere waned. This, indeed, is what Riyadh has done in the past in periods of pronounced price weakness. Instead, the Saudis have done the opposite. As Mark Dubowitz, executive director of the Foundation for the Defense of Democracies, points out, Saudi production rose from 9.6 million barrels per day in November 2014 to 10.2 million barrels per day a year later. In early January, the kingdom announced budget cuts to its normally coddled population to cope with low prices.

Over a year ago, intelligence and diplomatic sources in the Middle East told Newsweek that this would be part of Saudi Arabia's conflict with Iran. According to Dubowitz, with oil at $37 per barrel—seven dollars more than the price of Brent crude in mid-January—Iran would have to sell 7.5 million barrels of crude a day to return to its level before the economic sanctions. How much oil does the International Energy Agency believe Iran will produce six months after the sanctions are lifted? Slightly more than 3.5 million barrels per day. Iran's national budget last year was based on oil fetching more than $70 a barrel. Iran, in other words, likely faces budget cuts, thanks to its enemies in Saudi Arabia.

The precipitous decline in the price of oil has unnerved financial markets in the U.S., Europe and elsewhere. The U.S. shale oil revolution drove growth and job creation for years, and now that's unwinding. U.S. oil producers, unlike the Saudis, are shutting down wells in response to the crash. There is also the specter of upheaval in the junk bond market—which has heavy exposure to the shale oil business in the U.S. Analysts expect an increasing number of companies in the oil patch will be unable to service their debts. But as long as the Saudis persist in deploying their oil-price weapon, those production cuts won't affect the global price of a barrel.

Conventional economic thinking has always had it that lower oil prices benefit countries that consume a lot of crude, because that puts money in consumers' pockets—money that they then spend. And that mostly has been true. This time, though, there is evidence that the American consumer is pocketing rather than spending the savings—a sign of enduring fragility in an economy that can't seem to grow beyond 2 percent per year, the same rate that much of Western Europe has maintained for a long time.

If that is true, it's a problem. The U.S. consumer has always been the key prop under the domestic and the global economy. But, as Peking University's Pettis puts it, "if all of this [economic] uncertainty causes the savings rate to rise—not just in China but everywhere else too—our problems are compounded. The last thing we need is for even weaker demand, but it looks like we're going to get it." If he's right, then the biggest difference between the Asian crisis of the '90s and the one now unfolding will be clear enough: This one won't miss the rest of us.

What China's Economic Slowdown Means for the Rest of the World