Emerging economies

When giants slow down

The most dramatic, and disruptive, period of emerging-market growth the world has ever seen is coming to its close

Jul 27th 2013
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THIS year will be the first in which emerging markets account for more than half of world GDP on the basis of purchasing power, according to the International Monetary Fund (IMF). In 1990 they accounted for less than a third of a much smaller total. From 2003 to 2011 the share of world output provided by the emerging economies grew at more than a percentage point a year (see chart 1). The remarkably rapid growth the world has seen in these two decades marks the biggest economic transformation in modern history. Its like will probably never be seen again.
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According to a recent study by Arvind Subramanian and Martin Kessler, of the Peterson Institute, a think-tank, from 1960 to the late 1990s just 30% of countries in the developing world for which figures are available managed to increase their output per person faster than America did, thus achieving what is calledcatch-up growth”. That catching up was somewhat lackadaisical: the gap closed at just 1.5% a year. From the late 1990s, however, the tables were turned. The researchers found 73% of developing countries managing to outpace America, and doing so on average by 3.3% a year. Some of this was due to slower growth in America; most was not.
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The most impressive growth was in four of the biggest emerging economies: Brazil, Russia, India and China, which Jim O’Neill of Goldman Sachs, an investment bank, acronymed into the BRICs in 2001. These economies have grown in different ways and for different reasons. But their size marked them out as special—on purchasing-power terms they were the only $1 trillion economies outside the OECD, a rich world club—and so did their growth rates (see chart 2). Mr O’Neill reckoned they would, over a decade, become front-rank economies even when measured at market exchange rates, and he was right. Today they are four of the largest ten national economies in the world.

The remarkable growth of emerging markets in general and the BRICs in particular transformed the global economy in many ways, some wrenching. Commodity prices soared and the cost of manufactures and labour sank. Global poverty rates tumbled. Gaping economic imbalances fuelled an era of financial vulnerability and laid the groundwork for global crisis. A growing and vastly more accessible pool of labour in emerging economies played a part in both wage stagnation and rising income inequality in rich ones.

The shift towards the emerging economies will continue. But its most tumultuous phase seems to have more or less reached its end.

Growth rates in all the BRICs have dropped. The nature of their growth is in the process of changing, too, and its new mode will have fewer direct effects on the rest of the world. The likelihood of growth in other emerging economies having an effect in the near future comparable to that of the BRICs in the recent past is low; they do not have the potential for catch-up the BRICs had in the 1990s and 2000s. And the BRICs’ growth has changed the rest of the world economy in ways that will dampen the disruptive effects of any similar surge in the future. The emerging giants will grow larger, and their ranks will swell; but their tread will no longer shake the Earth as once it did.


The great return
 
 
The BRIC era arrived at the end of a century in which global living standards had diverged remarkably. Towards the end of the 19th century America’s economy overtook China’s to become the largest on the planet. By 1992 China and Indiahome to 38% of the world’s population—were producing just 7% of the world’s output, while six rich countries which accounted for just 12% of the world’s population produced half of it. In 1890 an average American was about six times better off than the average Chinese or Indian. By the early 1990s he was doing 25 times better.

There followed what Mr Subramanian and Mr Kessler call “convergence with a vengeance”. China’s pivot towards liberalisation and global markets came at a propitious time in terms of politics, business and technology. Rich economies were feeling relatively relaxed about globalisation and current-account deficits. Bill Clinton’s America, booming and confident, was little troubled by the growth of Chinese industry or by offshoring jobs to India. And the technology and managerial nous necessary to assemble and maintain complex supply chains were coming into their own, allowing firms to spread their operations between countries and across oceans.

The tumbling costs of shipping and communication sparked what Richard Baldwin, an economist at the Graduate Institute in Geneva, calls globalisation’ssecond unbundling” (the first was the simple ability to provide consumers in one place with goods from another). As longer supply chains infiltrated and connected places with large and fast-growing working-age populations, enormous quantities of cheap new labour became accessible. According to figures from the McKinsey Global Institute, a think-tank, advanced economies added about 160m non-farm jobs between 1980 and 2010. Emerging economies added 900m.


Riding the whirlwind
 
 
The fruits of this cheap labour were huge steps forward in global trade. Merchandise exports soared from 16% of global GDP in the mid-1990s to 27% in 2008. The Chinese share of global exports topped 11%, with trade accounting for more than half of the country’s GDP. Mr Subramanian and Mr Kessler see China as the firstmega-trader” to grace the world stage since Britain’s imperial heyday.
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The growth in trade was matched by a growth in demand for commodities as China and the nations supplying it soaked up energy and raw materials such as iron ore, copper and lead (see chart 3). Prices surged, generating a bonanza for the emerging world’s commodity producers and contributing to a broad-based boom, to the great benefit both of fellow-BRICs Russia and Brazil and of smaller economies, including many in Africa.

From 1993 to 2007 China averaged growth of 10.5% a year. India, with less reliance on trade, managed an average of 6.5%, more than twice America’s average growth rate. The two countries’ combined share of global output more than doubled to nearly 16%.

Global financial imbalances ballooned. From 1999 advanced economies ran a current-account deficit which peaked at nearly 1.2% of rich-world GDP in 2006. Emerging economies’ combined current-account surplus peaked in the same year at 4.9% of GDP.

Foreign-exchange interventions made the export surge doubly tricky to manage. After the financial crises of the late 1990s many emerging economies began accumulating dollar reserves to protect themselves against being caught short by big foreign-exchange outflows. Building up reserves helped the growing economies to hold exchange rates below the levels they might otherwise attain, keeping exports relatively cheap. China was a particularly enthusiastic reserve accumulator, and now sits atop a $3.5 trillion hoard, more or less all of it piled up since 2000. All told the BRICs have reserves of about $4.6 trillion.

This reserve accumulation contributed to a global savings glut, and the resulting low interest rates encouraged heavy public and private borrowing in the rich world. Some reckon currency manipulation also repressed consumption in emerging markets, so that their exports to big advanced economies like America were not offset by a corresponding rise in consumption of imports. Daron Acemoglu, David Autor and Brendan Price of the Massachusetts Institute of Technology, David Dorn, of Madrid’s Centre for Monetary and Financial Studies, and Gordon Hanson, of the University of California, San Diego, argue that the “sag” in employment growth in America in the 2000s can be blamed in large part on the country’s unreciprocated taste for Chinese imports.

Not all the effects of the BRICs’ growth were to be felt as promptly; some, for good and ill, will not be experienced in full measure for decades. Bigger economies mean bigger armies. They also mean flourishing universities: in 2030 China may have 50m more science and engineering graduates in its workforce than it did in 2010. And their growth has entailed an historic rise in greenhouse-gas emissions, now a third higher than they were in 1997, as well as heaps of local environmental damage. China is now the world’s largest carbon-dioxide emitter; America is the only non-BRIC in the top four.

But though the impact of the recent rapid change will be felt far into the future, the change itself is moderating. Various signs suggest that an important inflection point has been reached.

The emerging world will continue to grow in economic importance. But the pace at which it does so will slow as the BRICs put the days of their steepest ascent behind them.


Take a deep breath
 
 
The emerging economies’ share of output is no longer rising as fast as it did in the 2000s. In 2009 the year-on-year increase in that share was almost one and a half percentage points (see chart 1). Now it is back below one percentage point. This tallies with a striking slowdown in BRIC growth rates. In 2007 China’s economy expanded by an eye-popping 14.2%. India managed 10.1% growth, Russia 8.5%, and Brazil 6.1%. The IMF now reckons China will grow by just 7.8% in 2013, India by 5.6%, and Russia and Brazil by 2.5%.
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Unsurprisingly, this means that the BRIC economies are contributing less to global growth. In 2008 they accounted for two-thirds of world GDP growth. In 2011 they accounted for half of it, in 2012 a bit less than that.

The IMF sees them staying at about that level for the next five years. Goldman Sachs predicts that, based on an analysis of fundamentals, the BRICs share will decline further over the long term. Other emerging markets will pick up some of the slack. Yet those markets are not expected to add enough to prevent a general easing of the pace of world growth (see chart 4).

After two decades of rapid growth the most populous emerging economies have taken advantage of most of the easiest steps on the ladder to prosperity. An illustration: in 1997 none of the fastest 100 supercomputers in the world was to be found in a BRIC.

Now six computers in China grace that list, as do six from other BRICs. And one of them tops it: Tianhe-2, designed and built at the National University of Defence Technology in Changsha, crunches numbers faster tan any other device in the world. That is an extraordinary achievement, and the potential for growth as such technology spreads wider is clear.

But it is also an indication that the country’s growth will not now be as quick as it used to be. Bleeding-edge innovation is harder than catching up.

Other countries have impressive growth potential. Goldman Sachs touts a list of the “Next 11” which includes Bangladesh, Indonesia, Mexico, Nigeria and Turkey. But there are various reasons to think that this N11 cannot have an impact on the same scale as that of the BRICs.

The first is that these economies are smaller. The N11 has a population of just over 1.3 billion. That is less than half that of the BRICs. The N11 is barely more populous than India, which is the BRIC with the greatest possibility for growth still ahead of it, if only it could reform itself enough to put more of those people to work.

The second is that the N11 is richer now than the BRICs were back in the day. Economists reckon that the bigger the gap between a country’s output per person and that of the technological leader, the faster the economy is capable of growing. Weighted by population, the average per person output of the N11 is already 14% of that in America. When the BRIC economies began their economic surge their population-weighted output per person was just 7% of America’s. It is a measure of the continued potential for growth in India, where population has risen fast, that its figure today is still just 8%.
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It is not just the N11. The world as a whole has less catch-up potential tan it used to. Its most populous countries are no longer all that poor and its poor countries are no longer all that populous. Two decades of BRIC-led growth mean that there are far fewer people earning very little.

In 1993 about half the world lived at below 5% of American GDP per person, according to an analysis of IMF figures by The Economist (see chart 5). In 2012 the equivalent figure was 18% of American GDP per person.

The third reason that the performance of the BRICs cannot be repeated is the very success of that performance. The world economy is much larger than it used to be: twice as big in real terms as it was in 1992, according to IMF figures. That means that emerging markets—whether the BRIC economies or the N11 or bothmust deliver larger absolute increases in output to generate a marginal economic boost matching that seen in the 1990s and 2000s.

The same maths apply to labour markets. New additions to the workforce will henceforward have a harder time disrupting the global economy. The billion jobs that the McKinsey Global Institute sees as having been added to non-farm employment from 1980 to 2010 boosted it by 115%. If the world were to put on another billion jobs from 2010 to 2040 that would represent just a 51% increase in world employment: impressive but much less dramatic.


Making the best of it
 
 
The reality may be a good bit less dramatic still. Some developing economies will add hundreds of millions of new workers in coming years. But some of that contribution will be offset by the ageing of populations elsewhere.

China’s working-age population began shrinking in 2012. India, with more favourable demographics, is struggling to create enough employment; it added no net new jobs between 2004-05 and 2009-10, according to a recent survey. Big demographic booms are brewing elsewhere: Nigeria, for example, may be more populous than America in less than 40 years. But such growth will have its peak impact only decades from now.

The way that the world economy reacted to the rise of the BRICs has also made it less prone to further shocks of a similar sort. Markets have responded to soaring commodity demand and prices. Firms and households are saving on inputs; businesses and governments have rushed to develop new resources, as seen in the shale oil-and-gas bonanza now unfolding in North America.

Currency adjustments have narrowed deficits. The Chinese yuan has appreciated by roughly 35% against the dollar since 2005. Emerging-world reserve accumulation has diminished along with current-account imbalances. Since 2011 Chinese reserves have been mostly flat. Indeed in recent years reserve outflows have been a problem for some emerging markets.

An easing in the stride of the emerging-market giants will be cause for anxiety first and foremost for the residents of those countries, where the growth that has delivered higher living standards has also whetted appetites for more. The transition need not be painful. In China a slower overall growth rate may feel fine to workers if the share of consumption in the economy rises relative to investment. In India, though, the picture is not so pretty.

A rising tide may lift all boats; a falling one reveals who has no bathing trunks on. Weaker conditions could place pressure on financial systems in emerging economies about which investors begin to worry. If central banks fail to stem capital outflows then slower growth could give way to outright contraction. Many countries will find that commodities no longer provide a crutch. David Jacks, an economist at Simon Fraser University in British Columbia who studies long-run commodity-price movements, reckons that prices may have already begun a sustained period of below-trend price growth.

Internationally, lower growth could focus leaders on increased co-operation and a new push for liberalisation. The BRIC era took place in the absence of major new trade liberalisation (though China’s entry into the World Trade Organisation was an important landmark); with trade growing so healthily anyway, the rewards were harder to appreciate. A slowdown could bring new focus to global trade talks. A deal that addressed non-tariff trade barriers, and especially those on trade in services, could yield big benefits.

There is a risk, though, that matters may move in the opposite direction. The rich world is more cautious about globalisation than it was a decade or two ago, and more interested in maintaining its export competitiveness. A century ago the world’s last great era of trade integration ended with a war and ushered in a generation of economic nationalism and international conflict.

The recent proliferation of regional trade agreements could signal a move towards fractionalisation of the global economy. And slowed growth in the now-large BRICs could lead to the sort of internal tensions that countries can displace by picking external fights. Whether or not the world can build on a remarkable era of growth will depend in large part on whether the new giants tread a path towards greater global co-operation—or stumble, fall and, in the worst case, fight.


Buttonwood

Holiday hassles

There is scope for the markets to have another summertime wobble

Jul 27th 2013
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BEWARE the Ides of August. For a month associated (in Europe, especially) with holidays and long weekends, August has seen an awful lot of financial crises. Europe’s exchange-rate mechanism disintegrated in August 1993; Russia devalued the rouble and defaulted on its debt in August 1998; the credit crunch first made the headlines in August 2007; and stockmarkets wobbled again in August 2011, when America lost its AAA credit rating and the euro crisis raged.

Some of this is coincidence. But there is a plausible reason why August might see sharp price movements. Europeans head for the beach to escape clammy city centres. Even Americans, normally obsessed with showing their faces at the office, risk taking the odd day off.

Traders and active investors like hedge-fund managers will be tempted to close their most risky positions and take their profits. Junior dealers will be in charge of banks’ market-making desks, under strict instructions not to take any big gambles while the boss is away. It adds up to a market with very little liquidity, and thus one that is unable to absorb a lot of selling if bad news breaks.

What are the chances of an August meltdown this year? There is nothing inevitable about it. Some would argue that the markets already had a wobble in late May and June, as investors adjusted to the idea that the Federal Reserve would start to “taper” its asset purchases. With a Fed survey finding that 93% of investors expect tapering by the end of the year, that risk is now priced into the market.

Worries about a slowdown in China are also commonplace. A Bank of America Merrill Lynch (BAML) survey of fund managers found that those expecting slower Chinese growth outnumbered those predicting an upturn by 65 percentage points. As recently as December optimists outnumbered pessimists by a similar margin.

But investors do seem complacent about the global growth outlook. The BAML survey found that a net 52% of fund managers expected faster growth over the next 12 months. This is at odds with the general direction of economists’ forecasts, which are being revised down. On the back of this optimism, investors have above-average risk appetites. A net 52% have an overweight position in equities.

One source of an August wobble, therefore, might be belated concern about the prospects for global growth. In the year to the end of March nominal GDP growth in America, the world’s largest economy, was just 3.3%. According to Lacy Hunt of Hoisington Investment Management, an advisory firm, that is the slowest pace of any annual expansion since 1948. Core inflation, as measured by the personal-consumption expenditures index, is at a 50-year low.

Sluggish growth and falling inflation are normally good news for government-bond markets, but they recently suffered a big sell-off. The BAML survey found that a net 55% of investors were underweight bonds. So it is not hard to imagine a sudden rotation out of equities and back into bonds in the face of poor economic news.

Another risk relates to Europe. The economic data have improved a bit: the latest euro-zone purchasing managers’ index signalled growth for the first time since January 2012. But the euro zone’s politicians have still not come up with a lasting solution to the region’s problems; its banks are still weak. Everyone is waiting for September’s election in Germany, after which the region’s leaders may have more leeway to undertake reforms.

But there is plenty of scope for nasty surprises in the meantime. The Spanish prime minister is dogged by scandal. The Portuguese and Italian coalition governments look fragile. Silvio Berlusconi, a controversial former Italian prime minister, may face a ban from politics if a tax-fraud conviction is upheld on July 30th, an event that could spark turmoil.

The underlying problem for investors is that immense efforts by central banks have stabilised the financial situation, heading off the risk of a euro-zone break-up and preventing a 1930s-style slump in GDP. But they have not yet delivered the robust economic expansion that normally follows recession, nor have they put much of a dent in the debt burdens that set off the crisis in 2007-08.

Indeed, financial markets might not be able to withstand a return to normal. As Ben Inker of GMO, a fund-management group, puts it: “Today’s valuations only make sense in light of low expected [short-term] rates. Remove that expectation and pretty much every asset across the board is vulnerable to a fall in price.” A sobering thought to take on holiday.


Wall Street's Best Minds

WEDNESDAY, JULY 24, 2013

Recognizing the End of China's Economic Miracle

By GEORGE FRIEDMAN

Asia's largest nation will no longer be the "low-wage, high-growth center of the world," writes the chairman of Stratfor.

 

Major shifts underway in the Chinese economy that Stratfor has forecast and discussed for years have now drawn the attention of the mainstream media.


Many have asked when China would find itself in an economic crisis, to which we have answered that China has been there for awhile -- something not widely recognized outside China, and particularly not in the United States. A crisis can exist before it is recognized. The admission that a crisis exists is a critical moment, because this is when most others start to change their behavior in reaction to the crisis. The question we had been asking was when the Chinese economic crisis would finally become an accepted fact, thus changing the global dynamic.
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Last week, the crisis was announced with a flourish. First, The New York Times columnist and Nobel Prize-recipient Paul Krugman penned a piece titled "Hitting China's Wall." He wrote, "The signs are now unmistakable: China is in big trouble. We're not talking about some minor setback along the way, but something more fundamental. The country's whole way of doing business, the economic system that has driven three decades of incredible growth, has reached its limits. You could say that the Chinese model is about to hit its Great Wall, and the only question now is just how bad the crash will be."

Later in the week, Ben Levisohn authored a column in Barron's called "Smoke Signals from China."
He wrote, "In the classic disaster flick 'The Towering Inferno' partygoers ignored a fire in a storage room because they assumed it has been contained. Are investors making the same mistake with China?" He goes on to answer his question, saying, "Unlike three months ago, when investors were placing big bets that China's policymakers would pump cash into the economy to spur growth, the markets seem to have accepted the fact that sluggish growth for the world's second largest economy is its new normal."

Meanwhile, Goldman Sachs -- where in November 2001 Jim O'Neil coined the term BRICs and forecast that China might surpass the United States economically by 2028 -- cut its forecast of Chinese growth to 7.4 percent.

The New York Times, Barron's and Goldman Sachs are all both a seismograph of the conventional wisdom and the creators of the conventional wisdom. Therefore, when all three announce within a few weeks that China's economic condition ranges from disappointing to verging on a crash, it transforms the way people think of China. Now the conversation is moving from forecasts of how quickly China will overtake the United States to considerations of what the consequences of a Chinese crash would be.


Doubting China

           
Suddenly finding Stratfor amid the conventional wisdom regarding China does feel odd, I must admit. Having first noted the underlying contradictions in China's economic growth years ago, when most viewed China as the miracle Japan wasn't, and having been scorned for not understanding the shift in global power underway, it is gratifying to now have a lot of company. Over the past couple of years, the ranks of the China doubters had grown. But the past few months have seen a sea change. We have gone from China the omnipotent, the belief that there was nothing the Chinese couldn't work out, to the realization that China no longer works.

It has not been working for some time. One of things masking China's weakening has been Chinese statistics, which Krugman referred to as "even more fictional than most." China is a vast country in territory and population.

Gathering information on how it is doing would be a daunting task, even were China inclined to do so. Instead, China understands that in the West, there is an assumption that government statistics bear at least a limited relationship to truth. Beijing accordingly uses its numbers to shape perceptions inside and outside China of how it is doing. The Chinese release their annual gross domestic product numbers in the third week of January (and only revise them the following year). They can't possibly know how they did that fast, and they don't. But they do know what they want the world to believe about their growth, and the world has believed them -- hence, the fantastic tales of economic growth.

China in fact has had an extraordinary period of growth. The last 30 years have been remarkable, marred only by the fact that the Chinese started at such a low point due to the policies of the Maoist period. Growth at first was relatively easy; it was hard for China to do worse. But make no mistake: China surged. Still, basing economic performance on consumption, Krugman notes that China is barely larger economically than Japan.

Given the compounding effects of China's guesses at GDP, we would guess it remains behind Japan, but how can you tell? We can say without a doubt that China's economy has grown dramatically in the past 30 years but that it is no longer growing nearly as quickly as it once did.

China's growth surge was built on a very unglamorous fact: Chinese wages were far below Western wages, and therefore the Chinese were able to produce a certain class of products at lower cost than possible in the West. The Chinese built businesses around this, and Western companies built factories in China to take advantage of the differential. Sincé Chinese workers were unable to purchase many of the products they produced given their wages, China built its growth on exports..

For this to continue, China had to maintain its wage differential indefinitely. But China had another essential policy: Beijing was terrified of unemployment and the social consequences that flow from it. This was a rational fear, but one that contradicted China's main strength, its wage advantage. Because the Chinese feared unemployment, Chinese policy, manifested in bank lending policies, stressed preventing unemployment by keeping businesses going even when they were inefficient.

China also used bank lending to build massive infrastructure and commercial and residential property. Over time, this policy created huge inefficiencies in the Chinese economy. Without recessions, inefficiencies develop. Growing the economy is possible, but not growing profitability. Eventually, the economy will be dragged down by its inefficiency.

As businesses become inefficient, production costs rise. And that leads to inflation. As money is lent to keep inefficient businesses going, inflation increases even more markedly. The increase in inefficiency is compounded by the growth of the money supply prompted by aggressive lending to keep the economy going. As this persisted over many years, the inefficiencies built into the Chinese economy have become staggering.

The second thing to bear in mind is the overwhelming poverty of China, where 900 million people have an annual per capita income around the same level as Guatemala, Georgia, Indonesia or Mongolia ($3,000-$3,500 a year), while around 500 million of those have an annual per capita income around the same level as India, Nicaragua, Ghana, Uzbekistan or Nigeria ($1,500-$1,700).

China's overall per capita GDP is around the same level as the Dominican Republic, Serbia, Thailand or Jamaica. Stimulating an economy where more than a billion people live in deep poverty is impossible. Economic stimulus makes sense when products can be sold to the public. But the vast majority of Chinese cannot afford the products produced in China, and therefore, stimulus will not increase consumption of those products. As important, stimulating demand so that inefficient factories can sell products is not only inflationary, it is suicidal. The task is to increase consumption, not to subsidize inefficiency.

The Chinese are thus in a trap. If they continue aggressive lending to failing businesses, they get inflation. That increases costs and makes the Chinese less competitive in exports, which are also falling due to the recession in Europe and weakness in the United States. Allowing businesses to fail brings unemployment, a massive social and political problem. The Chinese have zigzagged from cracking down on lending by regulating informal lending and raising interbank rates to loosening restrictions on lending by removing the floor on the benchmark lending rate and by increasing lending to small- and medium-sized businesses. Both policies are problematic.

The Chinese have maintained a strategy of depending on exports without taking into account the operation of the business cycle in the West, which means that periodic and substantial contractions of demand will occur. China's industrial plant is geared to Western demand. When Western demand contracted, the result was the mess you see now.

The Chinese economy could perhaps be growing at 7.4 percent, but I doubt the number is anywhere near that. Some estimates place growth at closer to 5 percent. Regardless of growth, the ability to maintain profit margins is rarely considered. Producing and selling at or even below cost will boost GDP numbers but undermines the financial system. This happened to Japan in the early 1990s. And it is happening in China now.

The Chinese can prevent the kind of crash that struck East Asia in 1997. Their currency isn't convertible, so there can't be a run on it. They continue to have a command economy; they are still communist, after all. But they cannot avoid the consequences of their economic reality, and the longer they put off the day of reckoning, the harder it will become to recover from it. They have already postponed the reckoning far longer than they should have. They would postpone it further if they could by continuing to support failing businesses with loans. They can do that for a very long time -- provided they are prepared to emulate the Soviet model's demise. The Chinese don't want that, but what they do want is a miraculous resolution to their problem. There are no solutions that don't involve agony, so they put off the day of reckoning and slowly decline.


China's Transformation

           
The Chinese are not going to completely collapse economically any more than the Japanese or South Koreans did. What will happen is that China will behave differently than before. With no choices that don't frighten them, the Chinese will focus on containing the social and political fallout, both by trying to target benefits to politically sensitive groups and by using their excellent security apparatus to suppress and deter unrest. The Chinese economic performance will degrade, but crisis will be avoided and political interests protected. Since much of China never benefited from the boom, there is a massive force that has felt marginalized and victimized by coastal elites. That is not a bad foundation for the Communist Party to rely on.

The key is understanding that if China cannot solve its problems without unacceptable political consequences, it will try to stretch out the decline. Japan had a lost decade only in the minds of Western investors, who implicitly value aggregate GDP growth over other measures of success such as per capita GDP growth or full employment. China could very well face an extended period of intense inwardness and low economic performance. The past 30 years is a tough act to follow.

The obvious economic impact on the rest of the world will fall on the producers of industrial commodities such as iron ore. The extravagant expectations for Chinese growth will not be met, and therefore expectations for commodity prices won't be met.

Since the Chinese economic failure has been underway for quite awhile, the degradation in prices has already happened. Australia in particular has been badly hit by the Chinese situation, just as it was by the Japanese situation a generation ago.

The Chinese are, of course, keeping a great deal of money in U.S. government instruments and other markets. Contrary to fears, that money will not be withdrawn.

The Chinese problem isn't a lack of capital, and repatriating that money would simply increase inflation. Had the Chinese been able to put that money to good use, it would have never been invested in the United States in the first place. The outflow of money from China was a symptom of the disease: Lacking the structure to invest in China, the government and private funds went overseas. In so doing, Beijing sought to limit destabilization in China, while private Chinese funds looked for a haven against the storm that was already blowing.

Rather than the feared repatriation of funds, the United States will continue to be the target of major Chinese cash inflows. In a world where Europe is still reeling, only the United States is both secure and large enough to contain Chinese appetites for safety. Just as Japanese investment in the 1990s represented capital flight rather than a healthy investment appetite, so the behavior we have seen from Chinese investors in recent years is capital flight: money searching for secure havens regardless of return. This money has underpinned American markets; it is not going away, and in fact more is on the way.

The major shift in the international order will be the decline of China's role in the region. China's ability to project military power in Asia has been substantially overestimated. Its geography limits its ability to project power in Eurasia, an endeavor that would require logistics far beyond China's capacity. Its naval capacity is still limited compared with the United States. The idea that it will compensate for internal economic problems by genuine (as opposed to rhetorical) military action is therefore unlikely.

China has a genuine internal security problem that will suck the military, which remains a domestic security force, into actions of little value. In our view, the most important shift will be the re-emergence of Japan as the dominant economic and political power in East Asia in a slow process neither will really want.

China will continue to be a major power, and it will continue to matter a great deal economically. Being troubled is not the same as ceasing to exist. China will always exist. It will, however, no longer be the low-wage, high-growth center of the world. Like Japan before it, it will play a different role.

In the global system, there are always low-wage, high-growth countries because the advanced industrial powers' consumers want to absorb goods at low wages. Becoming a supplier of those goods is a major opportunity for, and disruptor to, those countries. No one country can replace China, but China will be replaced. The next step in this process is identifying China's successors.


Friedman is the founder and chairman of Stratfor, a geopolitical intelligence firm that provides strategic analysis and forecasting to individuals and organizations around the world.