There is an old expression from the 50s often thrown around in the financial market that says “when the U.S. gets a cold, the rest of the world gets pneumonia.”  A somewhat colloquial expression which attempts to convey the influence and impact that Wall Street and the U.S. has on the global financial market.  However, as we have all seen, nothing remains the same forever.  A new contender for the premier position has arrived on the scene.

China has been in the news a lot recently. Especially, with the recent turmoil in the financial markets. But just how important is China’s economy to the U.S. and the rest of the world?  Can what happens in China really influence and impact main street USA and the rest of the world?  Is China still an opportunity for investment? To answer all these question we need to a bit of searching into China’s rich and colorful history.

In the 1930s, China had carved out its position as the premier financial center of the Far East. This lofty title ended in 1949 following a bloody four-year civil war. Emerging on the scene was the victorious Peoples Liberation Army who immediately installed a communist form of government. From that moment to today China is known as the People’s Republic of China (PRC). The new regime set about to remake China in the image of their communist based ideology. Businesses became state-owned which meant that all profits generated were confiscated by the Chinese government. Supposedly a portion of all profits confiscated were used to purchase improved technology that would help modernize certain industries. However, because China at that time was a closed economic system, what little data that is available indicates that its total output (GNP) was extremely low. As a result the amount of funding for modernization was not that great. The end result of this situation was that China was unable to keep pace with the rest of the world and its economic growth was essentially zero. China soon found itself at a crossroad and realized that in order to survive in the emerging global market that it had to make some significant changes and do so quickly.

Change for China at that time was not easy nor was it quick.  The first break for China’s desire to change happened in 1971 when Dr. Henry Kissinger traveled to China. A year later President Richard M. Nixon became the first U.S. president to visit the PRC. His mission was merely to create more normal relations between China and the United States. However, his visit allowed the world to be exposed to the first images of China in over two decades. The trip by Nixon did helped the United States to create an alignment with their one-time, cold-war enemy.  It also opened up the potential of future trade between the two countries.

In case you might be wondering why China wanted to obtain growth and become more a part of the global market the answer is fairly simple. It’s a proven fact that a growing economy helps to bring about overall stability. History reveals that many country revolutions begin because the poor were oppressed by rich. When a country’s economy is stagnant for an extended period of time what we notice is the shrinking of the middle-class which brings about and expansion of the income disparity between the rich and poor.  The building tension results in destabilization of various elements that define that society and a weakening of the power structure of those in charge.  Hence, the Chinese leadership were eager to pursue and achieve real growth for China.

The task at hand for the Chinese leadership to even commence a growth strategy was staggering.  Hardliners inside the government did not want anything to do with a pseudo capitalistic program, they preferred status quo.  It was noticed early on by various Chinese leaders that to achieve their long range plans it would require allowing foreign investment of money, people and technology to come into China. Hardliners considered this to be a foreign invasion.  At that time, China didn’t have in place an adequate infrastructure (physical, intellectual and legal, business, etc.) to accommodate such an approach. Foreign companies were apprehensive to make any investment since China had a long history of changing the rules.  Needless to say, it took decades of work by all involved to get to a point where the trust and respect between China and potential offshore investors was sufficient to allow China to make small steps forward in the global market and their overall long term strategy.

China’s average annual rate of GDP growth from 1987 to 1996 was 10.2 percent compared to its inflation rate which averaged 12.1 percent. From 2001 to 2014, GDP grew at an average annual rate of 9.5 percent (0.7 percent less than the 1987-1996 period), but inflation was much lower, averaging only 1.9 percent. (See Chart) This is a unique situation since economic activity at this higher level normally fosters higher inflation rates. It would be interesting to learn how did China generate such a high rate of GDP with a corresponding low rate of inflation?

The emergence of China into the global market has been a remarkable transformation of their society.  Their continued double digit growth over the past few decades has been the envy of the world.  This is especially true since they have managed to keep internal inflation rates at very low levels.  However, this growth hasn’t been free.  China suffers from enormous pollution problems (i.e. air, land, water, etc.).  There has been constant infighting between high level Chinese officials regarding is it better for China to continue as the main exporter of goods or to rely more on developing an internal market for its products.  This internal conflict has led to a bit of chaos and confusion in many parts of the government and related industries.  As economic conditions around the globe slowed or even stagnated China noticed a significant drop in its exported goods.  At the same time, the fledging rise of a middle class inside China also slowed as companies reacted to the fall off of exported goods. In short, people stopped buying.

All this was happening at a time when China’s financial centers (stock market) was showing fantastic growth.  In the May/June, 2015 time period the Shanghai Composite peaked at more than 5,100 points, a gain of roughly 150% over the previous 12 months. When the China bubble burst, that index lost 32% of its value in just 18 trading sessions. The most recent decline follows on the heels of another huge decline in July, the combination of which has erased the Chinese stock market’s 2015 gains entirely. As the reader recalls, stock markets around the world dropped as well following the massive Chinese losses.  This fact reinforces the opinion that China is a dominant factor in the global financial market.

But what does this mean for China, what’s the real impact of a falling stock market inside China? In truth, China’s stock market is not a major part of the Chinese economy, so it’s unlikely that this recent crash alone will expand the economic crisis there. Overall, the stock market plays a fairly limited role China’s economy. Relatively little Chinese wealth is stored in shares. More is held in property.

However, the internal political consequences of a falling stock market could be serious. There is a continuing debate going on within China’s leadership over what to do about the economy, and this latest stock market turmoil could push that debate in a very wrong direction.

It’s entirely possible that the crash might bolster political factions inside China that want to block critical economic reforms, and weaken factions that do want these reforms.  Most experts believe that China need to proceed with serious economic reforms which are very important for the country’s future. Without these reforms, China will most likely face far more severe economic problems and the fall out will be felt by most other countries around the globe.

Internally, there is a strong driving force to bring about some level of economic reform within China.  That force comes from President Xi Jinping. Just three years after taking the reins of power, Xi has already placed his stamp firmly on his country, his region and China’s relationship with the rest of the world.  A number of China experts have postulated that Xi is perhaps the most powerful Chinese Leader since Mao Zedong. Unlike his predecessors who preferred a relative low profile, Xi has employed what could best be called “Strongman Tactics” to achieve his objectives at home and abroad.  Shortly after his rise to power Xi commenced a consolidation of personal power through a massive crackdown on corrupt Chinese officials at all levels and also civil activists. As it turned out many of the corrupt Chinese officials happened to be Xi’s political rivals. His relentless attack on corrupt officials and civil activist has raised grave concerns with a number of China watchers.  Some feel that Xi’s strategy for China isn’t a vision of electoral democracy.  Instead, it’s fairly clear that he wants a more efficient authoritarian state with a strong leader at its helm, namely Xi.

As aggressive as Xi has been in consolidating his power base inside China he has also made his mark in the international arena.  We have seen China assert its territorial claims by constructing artificial islands in the South China Sea, placement of airstrips and outpost on those islands all over the objections of the U.S. and its various allies.  By the way, those islands are still there, the airstrips are still there, Chinese personnel are still there and all of this appears to be expanding.  Xi has also done the same thing in waters claimed by the Philippines and Vietnam.  Not all actions by Xi have been regarded as hostile.  He is expanding Chinese influence in Southeast and Central Asia through the founding of new international organizations and providing huge sums of money to promote infrastructure investments abroad.

Actions at home and abroad has provided Xi with enormous popularity and political capital.  His move to shrink the role of the central government by giving market forces a more decisive role in China’s economy has caused many of his supporters to refer to Xi as “The Reformer.”

In truth, Xi is pursuing a genuine reform agenda.  He is hoping to move the Chinese economy away from historical sources of growth which relied on cheap exports, heavy industry and cheap labor. Xi is committed to a new economy, one that is based on a more Western definition of Service, Consumption, Innovation and market leadership.  However, progress has at best been spotty.  Xi has achieved a small movement of the Chinese economy away from industries such as steel and cement (both of which are also high polluting sources). However, in an example of taking one step forward and two backwards, when the Chinese stock market bubble began to burst, the Xi leadership pumped in money, reduced interest rates in a desperate attempt to keep the stock market going. That move and a sudden devaluation of the RMB fueled speculation that Xi may be willing to sacrifice deep reform in the hope of securing short-term growth.

Xi has pursued a strategy to build his public image as a strong leader devoted to the Chinese people. There are no accurate polls in China that would assess how successful Xi has been with this strategy but anecdotal evidence suggest Xi is extremely popular at home.  Even with enormous personal power, popular support the question becomes “Can Xi transform the Chinese Economy without causing a hemorrhaging of unemployment and dissatisfaction at home?” Xi has made a lot of powerful enemies along the way, all of whom would like to see him fail and return China to a more status quo situation.  Xi’s continued head butting with the U.S. and other countries over his overt actions in the Southeast Asia arena carries with it enormous risk.  U.S. President Barrack Obama has only slightly more than 12 month remaining in his term.  The next President may see the world very differently which could raise the tension level between China and the U.S.  Such an action would negatively impact on Xi’s ambitious reform plans for China.  We probably want know the outcome of all of this for several years.  However, there is one thing that we do know.  With Xi almost guaranteed another seven more years in power, the U.S. and its allies will need to wrestle with China relations in the age of Xi, a man with a vision and the ability to make that vision reality.

China is here to stay. Their influence in the world market is solid and will only grow over time.  The world powers now include China and in truth, China and the other nations need each other. True, the China growth strategy is slowing down.  How much decline is difficult to determine.  China maintains that their GDP will drop from double digits to a more normal seven percent level.  Various China watchers feel that the real GDP number for the future of China may well be in the four percent level. Of course, the U.S. would be delighted to see a sustained GDP of four percent or better. Don’t expect to see a mass exit of foreign investors from China because of this economic slowing. Businesses and Countries have all become a committed part of the future of China. China is still regarded by a number of economist as an opportunity even though it may be approaching what some regard as a “maturing position.” Like all investments, China investors should do their due diligence before jumping into anything.