David Skilling: When China shakes the world

After another bad week for Western (or more precisely, Anglo) political leadership – from the revelations in Mr Comey’s Senate testimony, to the political uncertainty in the UK after a remarkably poor election campaign – it is worth thinking about China’s emerging position of global leadership.

This emergence is partly due to US withdrawal on global issues like trade and climate change. But the behaviour of the US is simply accelerating what was an inevitable rebalancing of economic and political leadership.  China overtook the US as the world’s biggest economy (in PPP terms) in 2014, and may well become the largest economy on market exchange rates in the next few decades (although there are many risks to this, as noted below).

In one sense, this is a return to the status quo ante.  Angus Maddison’s long term economic data shows that as recently as 1820, China was the largest economy in the world; before self-imposed isolation, the Industrial Revolution in the West, and disastrous economic policies until the 1980s. 

China is now returning – and doing so at speed and scale. China accounted for 15% of global GDP (in USD terms) in 2016, up from a 5% share in 2005. China now accounts for about 30% of global GDP growth (in PPP terms), about the same as the entire advanced economies group; in the decade prior to the crisis, it averaged around 15%.  And China accounts for 10% of global imports (in USD), up from 5% in 2005.  This dwarfs previous episodes of development.  At its peak, for example, Japan made a 10% contribution to global GDP growth; it never came close to the US.

China’s rise has had substantial effects already, from inflation outcomes to labour markets in advanced economies (which in turn has had an impact on the politics of globalisation in many developed countries).  And, of course, China supported global growth through the crisis period.

But looking forward, I see two key differences relative to previous periods of transition, such as from Britain to the US, which suggest turbulence ahead.

First, China is assuming a leadership position when it is still a middle income country: China’s per capita income is just 27% of the US in PPP terms (14% in USD terms).  Emerging markets have higher, but more volatile, growth paths.  And they tend to have less well developed economic and political institutions.  China’s financial sector is one obvious manifestation of this higher risk profile.  Corporate leverage in China has increased very substantially, and the incremental debt associated with incremental GDP growth has been increasing steadily.  These issues have not yet been addressed structurally, and aiming to ‘grow out of the problem’ – as they have done previously – is increasingly challenging.

The history of emerging markets also shows that many are unable to sustain strong growth through middle income stage.  And as Larry Summers noted a few years back, simple regression to the mean analysis suggests a likelihood that China’s growth will reduce sharply even without a crisis.  This is compounded by China’s aging population; the IMF warned last month on the structural risk that China ‘gets old before its gets rich’.

China is so large and diverse that it is difficult to draw international parallels with confidence. But China has an unusually high economic and financial risk profile as it moves to a position of global economic leadership.  That the country at the centre of the global system has such a high risk profile makes the entire global economic and financial system risky.  A hard stop in China’s growth would shake the global economy.  Other Asian economies are increasingly tightly integrated into a regional system that is highly exposed to Chinese demand.  And countries in Europe are also increasingly linked to China directly, as well as through supply chains and financial flows.  When China sneezes, the rest of the world will catch a cold (or worse). 

The second key difference is that China is not an active supporter of the existing liberal, rules-based system. China has benefited from these institutions, and is not looking to fundamentally overturn them.  But it has strong mercantilist tendencies, and deliberately uses its economic muscle to advance its broader external strategic interests.  Initiatives like OBOR, for example, may be economically useful, but they are not value-free.

This is not unique to China of course: the British Empire was both economic and geopolitical, and the set of global institutions established after WWII also benefited the US.  But the differences between China and the norms and behaviours embedded in the current system are marked, and will lead to friction as the transition proceeds (even if concerns about the Thucydides Trap can be over-stated). Although the optics of the recent talks between Premier Li and Chancellor Merkel were positive, for example, reaching substantive agreement with China on issues such as climate change and trade will not be straightforward given these differences.

And as countries in the region know well, economic reliance on China creates exposure to political pressures.  China is adept at boycott diplomacy, imposing sanctions on countries that it has disputes with.  Recent examples include South Korea (tourism restrictions after the deployment of the THAAD missile system), Norway, and Japan.  Hong Kong is becoming increasingly integrated economically and politically into mainland China, and China is using a mixture of carrots and sticks to apply pressure to the ASEANs.  A successful, assertive China will create many challenges for other countries in the region – as well as economic opportunities. Although so too would a weak, frustrated China.

To put it simply, China is too large and different to be a status quo power.  The scale and speed of China’s economic rise means that it is increasingly having a disruptive global economic and political impact.  And perhaps nowhere more than on small advanced economies, deeply exposed to the global economic and political environment. For better and worse, China will shake the world.

Dr David Skilling, the Director of the Singapore-based Landfall Strategy Group, was formerly the Chief Executive of the New Zealand Institute and before that, a Principal Advisor at the New Zealand Treasury.