BIG PICTURE

EMERGING-MARKET WATCHERS PROBABLY AREN’T FIGURING OUT THE BEST WAY TO EAT EGGS WHEN YOU HEAR THEM ARGUE ABOUT HARD VERSES SOFT. IT IS MORE LIKELY ABOUT ECONOMIC POLICY IN CHINA AND WHETHER OR NOT IT HAS DONE ENOUGH TO PREVENT ANOTHER GLOBAL CRISIS.

China’s current woes won’t be solved very easily.

China was one of the poorest nations on the planet in 1978 when it initiated economic reforms that transformed the country into an economic powerhouse. Since the mid- 1980s, when Chinese GDP growth topped 14%, the average annual rate of economic expansion has been 9.8%. Even the so-called Great Recession didn’t slow China down.

However, in the first quarter, when the U.S. economy was contracting due to a rough winter, China’s GDP growth came in at 7.4%, its slowest level in 18 months, due to weakening demand and policy moves aimed at dealing with over-stretched property developers and municipalities. As a result, even some formerly bullish market watchers started running with the bears who think China (and everybody else) will soon pay the piper for its long run of good fortune.

With the global economy still on life support, the last thing central bankers need is a Chinese financial crisis, especially now with military conflicts in Ukraine and the Middle East. Since Q1, of course, China’s GDP has stabilized and a growth rate of at least 7.4% for the year now looks attainable thanks to improved demand and business conditions. Signs of a strengthening U.S. economy, which posted an annualized rate of growth of 4% in Q2, also have some market watchers breathing easier. But the stabilization of China’s economy has been driven by policies that exacerbate serious problems, including a reversal of measures put in place to keep official lending under control. Meanwhile, the shadow banking system is still an active driver of growth. As a result, debt levels of shaky municipalities, developers and businesses continue to increase.

China will eventually have to deal with its problems, which include more than debt and overcapacity issues. As noted by economist Robert Kennedy, dean of Western University’s Ivey Business School, there is a dichotomy between China’s Wild West economy and its centrally controlled political system. “At some point,” Kennedy recently told the Ivey Business Journal, “the economy and government system must come more into alignment. Either the politicians will move to exert more control over the economy, which would be hard, or the freedoms that citizens are used to in the market will lead to pressure for more political freedom. How the tension between economics and politics gets resolved is going to be something that will affect the whole world.”