Can the world adjust to China’s ‘new normal’?

The rise of China as an economic and trading superpower over the past decade has been striking in its scale and impact, domestically and internationally. Its economy has roughly doubled since 2009 and now challenges the US as the world’s largest economy (subject to various different metrics). Chinese growth has been a stimulus to the world, providing a large and growing domestic market, as well as a source of foreign direct investment and low-cost exports. And with economic strength has come geo-economic influence.

In 2015 and early 2016, however, worries over the pace of growth and composition of China’s economy and its policy-making skills have led to a significant and rapid change of sentiment. For countries increasingly dependent on a newly questionable Chinese growth model, could their relationships with the world’s second largest economy have become an economic liability rather than a strength? And, as the Chinese economy shifts, could Beijing’s geo-economic influence change too?

The changing Chinese economy

In the weeks leading up to the 2015 Annual Meeting of the International Monetary Fund (IMF) in Lima, Peru, headlines warned of IMF staff concerns about the risks of contagion emanating from China. Questionable Chinese government growth forecasts, unpredictable currency movements, steep declines in a nascent stock market and a suddenly unpredictable, unreliable and unsteady economic policy response in Beijing were the biggest global economic risks to be addressed by the world’s leading economic policy-makers.

These concerns increasingly focused on the implications of a Chinese slowdown and questionable policy responses. As global economic and finance leaders met in October 2015, China migrated from being a “spillover taker”, poking US and European officials over perceived policy missteps that affected countries around the globe, into now being itself a “spillover maker”. Slower growth, currency shocks and a transformation of its economy from infrastructure and investment dominated to consumption and services threatened to upend economies that depended on domestic Chinese infrastructure spending and investment.

Spillovers

It is too early to know how the Chinese economy will evolve and what the cross-border economic impacts of its transformation will be. Linkages are complicated and poorly mapped or understood. Still, as a rule of thumb, the IMF has estimated that each 1% decline in Chinese growth leads to a 0.3% decline in growth across Asia. In ASEAN countries, the decline could be as much as 0.6%, and in East Asia, the impact could be even higher, perhaps 0.7%. Even these broad estimates are imperfect, as there is little concrete data to parse impacts into those caused by slowing growth versus those driven by rebalancing of the economy. With the composition of China’s economy expected to increasingly shift to services and domestic consumption, other economies that were overly dependent on the “old” Chinese growth model – particularly commodities and capital goods producers – find themselves struggling to shift their own growth models.

Moreover, in spite of limited financial linkages and exposures, as 2016 commenced, Chinese stock market declines proved to have global contagion effects, with even US investors starting the year reacting to Chinese market and currency movements and policy choices. Continued uncertainty in the future of China’s domestic economic model, financial stability and policy response functions have further contributed to increasing pressure on private capital outflows, with Chinese citizens and entities seeking to diversify and find safer havens for their money. This has led to increasing downward pressure on the RMB versus its traditional peg to the US dollar. To maintain promised stability in the currency, the Chinese central bank has been forced to spend significant reserves (well over $450 billion since June 2015 alone). Nevertheless, the RMB has continued to weaken.

Regional trading partners are exposed to these monetary spillovers, with both direct and indirect impacts on their economies and the wealth of their own citizens. People’s Bank of China policy choices have increasingly significant impacts on the economic, financial and monetary health of other nations, which are forced to react, with little input into decisions taken that affect them on multiple levels.

Chinese leadership and policy-makers have never confronted their role as an external catalyst for disruption and risk. With an explicit focus on domestic benefits of economic and financial sector policy decisions, the reality that, like it or not, these decisions are now global in their impact, represents new territory, with highly uncertain results as yet to be fully understood, digested and integrated into the Chinese policy-making process.

Consequences for Chinese geo-economic influence

Strong Chinese growth has largely been good for other economies, something Chinese officials point out frequently. Slowing growth, market volatility and increasing spillovers could thus lead to political blowback, increasing the risks that other countries experience a rise in resentment towards China, with implications for Chinese relationships. Economic and financial decisions taken in China to address domestic growth-related goals could thus directly affect Chinese economic and strategic power abroad

It stands to reason that the shifting composition of those accessing Chinese domestic markets could also alter the slate of countries over which China wields influence. For example, commodity exporting countries dependent on China to support their own economic growth model, may find themselves less tethered to China’s economy, and thus able or forced to rethink economic, financial and, indeed, political decisions to reflect this new economic relationship. At the same time, as China becomes more focused on internally generated growth rather than export-driven trade, their incentives and agendas in engaging in multilateral rules-based trade and economic regimes may be reviewed and reprioritized.

A debate has begun over whether a less trade-dependent and more domestically focused China will become more adamant about international economic policy positions, feeling both stronger as their overall economic position continues to increase, and less dependent on existing rules and norms to ensure continued domestic economic health. This is, however, far from clear, with other observers pointing towards China’s continued interest in joining mega-regionals, such as the Trans- Pacific Partnership, as evidence to the contrary.

Economic governance

Over the past decades, Chinese economic strength has not only translated into ad hoc influence, it has also enabled Beijing to begin building institutions to combine and concentrate its economic strength and broader strategic and political goals. Nowhere has this been more evident than in the international investment arena, where its efforts to mobilize official sector funds for development and infrastructure projects through the Asian Infrastructure Investment Bank, BRICS Bank, and “One Belt One Road” initiatives.

Some argue that Chinese economic weakness and rebalancing may, paradoxically, actually strengthen these initiatives. As Chinese domestic infrastructure investment slows, Beijing has seized the opportunity to export excess capacity in industries such as construction and steelmaking. Overseas infrastructure investment via multilateral institutions is seen as a means to create less political friction than if they were undertaken bilaterally. These new institutions are intended to provide greater predictability, transparency, and accountability, and to allow Chinese overcapacity to be deployed internationally. However, both the scale and speed of such new projects, as well as the potential backlash from recipient countries finding their own domestic projects benefitting Chinese firms and workers and not their own, makes the outcome of this perceived strategy subject to skepticism.

An increasing global impact

For all the benefits China’s economic engine has provided to the world over the past decade, shifts in the composition of its economy have increasingly global impact. Slower growth and structural transformation threaten to upend economies that had grown overly dependent on Chinese growth and investment. Increased focus on the Chinese currency and monetary policy, as well as on the country’s stock markets and financial sector pose new and unknown threats to Chinese policy-makers unaccustomed to grappling with global consequences of what have been heretofore seen as domestic policy choices. China’s increasing centrality to the world’s economy and to the institutions and norms that govern global trade, commerce and financial flows, represents both new opportunities and risks.

One thing is increasingly certain: China can no longer argue that it is a passive recipient of the policy choices made by others. The impact of Chinese policies are now felt globally. Historically, these have been for the greater good. How the government reacts to its new role and responsibilities will determine the direction of its future trajectory on the international economic policy stage.

This is an extract from a report by the Forum's Global Agenda Council on Geo-Economics. Read the full report here.

Authors: Elizabeth Economy is a senior fellow and director for Asia studies at the Council on Foreign Relations; Michael Levi is the David M. Rubenstein senior fellow for energy and the environment at the Council on Foreign Relations; Douglas Rediker is a visiting fellow at the Peterson Institute for International Economics