Made In China: The Next Global Recession

The Chinese stock market had been open only 3½ hours on the first trading day of the year when it began to implode. A sharp depreciation in the Chinese currency and bad news from the manufacturing sector prompted a rapid plunge in stocks. The 7% drop was so severe, it triggered so-called circuit breakers–electronic hand brakes of sorts–that stop trading if stocks tumble too quickly. The brakes were supposed to halt panic, but instead they spooked the financial world. London, New York City and other global markets dipped sharply after they opened as nervous traders mulled worrisome cues from the world’s second largest economy. Many remembered keenly similar China-bred market turmoil last August.

Markets eventually stabilized after Chinese “national champions,” big state-run firms and funds, went on a Beijing-directed buying spree. But by Jan. 7, the Chinese markets were crashing again, this time only 12 minutes after opening, triggering more circuit breakers. Authorities tried to get the Shanghai and Shenzhen exchanges up and running just a few minutes later. At 9:59 a.m., two minutes after trading resumed, they were down again. The Chinese currency was in free fall, and normally cautious Chinese policymakers were lurching about for the right moves to stabilize markets. Again worldwide exchanges recorded big opening losses, and global investors struggled to understand what was happening in this usually predictable state-run economy. In the end, the global economy ushered in 2016 with Wall Street’s worst five-day start in history, one killer New Year’s hangover.

And yet as far as stock-market crashes go, this wasn’t a disaster of Lehman Brothers proportions. After all, Chinese stocks make up a minuscule portion of the global equity markets, and the Chinese have a ring-fenced state-run banking system. This wasn’t a too-big-to-fail event; indeed, a number of global markets, including the U.S., rebounded relatively quickly once it was clear that Chinese central bankers and regulators were standing by, as per usual, to buoy markets in one way or another, at least for the time being.

Still, especially if you have had the courage to look at your 401(k) recently, you could be forgiven for asking, What the hell is going on? The world, after all, is seven years into economic expansion. America has been in a steady, if thrill-less, economic recovery since 2009. And the most recent U.S. jobs numbers were great, finally driving unemployment down to normal levels. President Barack Obama wasn’t wrong to wax about the resilience of the American economy during his final State of the Union address on Jan. 12. And yet there has been more stock-market volatility over the past few months than in all of the past several years combined.

Here’s the hard truth you must accept to understand what’s happening in global markets these days: The problems that caused the Great Recession were never really fixed. Debt, which is always the root of financial crises and their resulting recessions, didn’t go away–it just found new places to flourish around the world. Back in 2008, the U.S. had a debt bubble driven by a gonzo real estate market that exploded and brought global markets low. Today China has cooked up its own epic debt bubble, which has grown at about three times the rate that the subprime bubble did. (The pace of debt run-up is the best measure of the danger it can cause.) It also has its roots in real estate, not to mention a financial system even more dysfunctional than the one the U.S. has and a political system equally hamstrung by vested interests.

China’s debt bubble is now popping. And the country that has made up the largest single chunk of global growth over the past several years is in a major slowdown, one that is for all intents and purposes a recession. That, along with growing worries that China’s once lauded economic technocrats may not be able to fix things, has destabilized global markets. The result is a metastasizing crisis that doesn’t give a fig for international borders or show any signs of slowing.

The measure of normalcy in the global economy over the past few years was guaranteed by a period of unprecedentedly low interest rates. It was also helped along by a $29 trillion infusion of public cash into private markets in practically every nation, engineered by the world’s governments and central banks. The U.S. Federal Reserve, first and foremost, propped up growth following the financial crisis.

But the Fed’s money dump, known as quantitative easing, ended more than a year ago. That’s when markets got jittery. In December, Fed chair Janet Yellen and other central-bank governors drew another line in the sand with the first U.S. interest-rate hike since 2006. Market volatility has been elevated since then.

When rates rise, it’s supposed to mean the economy is getting stronger, which in the U.S. it has been, at least in terms of job creation. But as too many Americans know too well, there is little or no real wage growth, which is very unusual at this point in an expansion. That is especially problematic in an economy like the U.S.’s, 70% of which is consumer spending. There are more jobs, but not the kind that put more money in people’s pockets or make it possible for consumers to drive demand in the global economy. We have a “recovery,” but in many ways it is a genetically modified recovery, not created by real growth on Main Street.

Thanks to four decades of globalization, the U.S. doesn’t carry as much weight in the world economy as it used to. During the Asian financial crisis of the late 1990s, for example, U.S. growth powered ahead despite troubles in much of the rest of the world. But the Chinese economy has grown wildly since then. China made up about a third of all global growth over the past decade, even more than the U.S., which made up only 17%. “This represents a major break from the past,” says Morgan Stanley Investment Management chief macroeconomist Ruchir Sharma. “Historically, the U.S. has been the single largest contributor to global growth, and a contraction in the American economy has been the catalyst that tipped the world into recession.”

Now the next global recession is likely to be made in China. The Middle Kingdom and other emerging markets (many of which rise and fall on Chinese economic news) make up 40% of the entire global economy, so what happens there matters more than ever. While questionable Chinese government statistics still claim that the country is growing at 7% a year, Sharma puts that figure closer to 4%. Other longtime China observers say it’s even lower. In China, that level of growth feels like a recession–a fear that President Xi Jinping acknowledged at November’s APEC meeting, when he pledged that China was “working vigorously to overcome difficulties and meet challenges by strengthening macro regulation and effectively advancing reforms.”

Indeed, most of the world’s top economic forecasters have begun to wonder if 2016 will bring a full-blown global recession. Already, most of those forecasters are predicting serious market turbulence in the weeks and months ahead. “Historically, global recessions happen every eight years, and we’re in the seventh year of an expansion,” notes Sharma, “so based on past data, it’s quite likely.”

When American consumers stopped buying stuff after the 2008 subprime crisis, China tried to take up the slack in the form of a massive government stimulus program. This meant a major run-up in its debt: a few years back, it took a dollar of debt to create every dollar of growth in China. Following 2009, it has taken four times that. And even today, debt in China is still rising about twice as fast as growth. Why is that a problem? Because financial crises are caused by fast run-ups in debt–and aside from wars and high inflation, financial crises are mainly what slow down the global economy. In this context, China’s unprecedentedly fast debt run-up is particularly worrisome.

A couple of years ago, the China bubble started to burst. The Chinese government tried to stop it by propping up one market after another, from housing to stocks. Last July, the government spent more than $400 billion to shore up overpriced stock markets before giving in to gravity and letting the markets fall.

Many global markets rebounded after the Chinese authorities made it clear that big state-run companies would continue to buy up Chinese blue-chip stocks to support the country’s main bourse, the Shanghai market. Beijing also said that bans on big institutional-investor stock sales, which had been set to expire, would continue. The markets simply needed this institutional underpinning; as the past few weeks have made clear, investors are all too willing to cash out of Chinese investments and put their money someplace with more political and economic certainty the minute they can. But China is now in a catch-22 situation, since the very fact that authorities have to take such actions means they aren’t in control of the markets, and that further erodes investor confidence.

In a way, this is partly good news–China has to cede more state control to the market system while bringing growth to a more sustainable level in order to move up the economic food chain. But the unpredictability of policy decisions around that is cause for concern, says Mohamed El-Erian, chief investment adviser for financial-services company Allianz. “The Chinese are in new territory, adapting to a more free-market situation that they know less well. They learn quickly, but there will be a learning curve,” he says.

That learning curve has already proved costly. Nearly a trillion dollars of capital have left China since 2014 as many investors try to get their money out of the country. That has forced the government to open up its $3.3 trillion war chest of foreign-currency reserves to prop up the renminbi, which is trading at much lower levels in Hong Kong than on the mainland–an indicator that investors think the Chinese markets and economy have further to fall.

That might sound like a lot of money, but reserves were around $4 trillion at the beginning of last year, a marker of how fast they are being run down, and experts like Sharma say that only around two-thirds of those reserves are liquid, or easily accessible in a pinch. “So, how big is that war chest, really?” he asks. “For years, we’ve had this idea that the Chinese are these very competent technocrats and that they have plenty of money to cover all the debt they’ve built up. But today we estimate that about half of the new loans being doled out in China are going to pay interest on the existing debt load.”

The current volatility in the markets, which will likely continue through 2016, reflects worries about whether authorities will be able to move smoothly from a state-run economy to a consumption-led one. It’s a shift that only three countries in Asia have ever made–Japan, South Korea and Singapore–and none of them had anywhere near the population of China, nor the opacity of decisionmaking that is characteristic of China’s Communist Party leadership. All this, combined with the back-and-forth policy moves, has resulted in “a low level of trust in what the market hears” from Beijing, as a recent Deutsche Bank analysis concluded.

Meanwhile, there are new worries about the U.S. Its export sector has been struggling for some time, in part because a strong dollar has made U.S. goods more expensive in the global marketplace. That’s a big problem, because net exports have contributed twice as much to this recovery as to recoveries of the past.

The Fed is raising rates and the dollar is rising, but the rest of the world is still moving in the opposite direction, creating a “Great Divergence” in monetary policy. That will take the global economy into new territory and likely contribute to more market turbulence as investors struggle to figure out where to place their bets in a world where asset prices and classes no longer move in sync.

Although U.S. consumers are no longer a source of instability, neither are they a source of growth. Americans have off-loaded plenty of personal debt in the wake of the crisis and cleaned up their household balance sheets. But unlike in recoveries past, spending hasn’t picked up, despite the rise in stock and housing wealth over the past few years. That’s very unusual–over the past 30 years, as soon as the prices of assets like stocks and homes began to rise, people typically felt more secure, reducing their savings and spending again.

Since the Great Recession, something else has changed. U.S. net wealth has increased by $20 trillion since 2012, thanks to gains in both stock markets and housing. But the personal-savings rate, which now hovers around 5%, is about twice what it should be given such gains, according to research by JPMorgan.

The root cause, say economists, could be in part our collective age–people spend less as they get older. But it may also be the fact that most of that stock and housing wealth is accruing within a small subset of the population–the top 10% of the population owns nearly 90% of all stocks–even as real wage levels remain virtually flat. That means that only the wealthy feel more economically secure, and there are only so many cars, homes and designer trinkets they can buy.

This has been a drag on the U.S. recovery, and it may be a permanent one. History shows that when consumers go through a seismic economic event, it changes their behavior over the long term. Think about Depression-era grandparents who save tea bags, or boomers who fueled the economy with their postwar spending. It could be that the financial crisis of 2008 and the recovery that followed, which has been the longest, slowest one on record, has bred a new type of American consumer, one less willing (not to mention able) to consume. In any case, aging demographics in developed countries like the U.S., European states and Japan don’t bode well for growth, which is essentially a function of working-age population and productivity combined.

So where does that leave us? Struggling to find a safe way forward in a new world, one that developed countries helped create. Globalization, fueled by Western neoliberal economics and the American economic miracle of the past century, has ushered in a more diverse and far richer global market. Free markets–if sometimes inefficient and periodically prone to crisis–won over competing models. But as a result, America must share center stage and can no longer pull the world forward alone.

The global “rebalancing” that many economists and policymakers had hoped for following 2008–a shift in which the world could depend more on China and other emerging markets, and less on U.S. consumption–hasn’t really come to pass. We still live in a global economy that is driven by debt rather than productive investment. Low wages impede productivity gains. Inequality is a further drag on growth. And emerging markets can’t yet offset the long-term slowing of developed nations. In economics, as in geopolitics, it’s now a world in which there is no single superpower.