China’s European and American partners should prepare for when China will need to rebalance its economy as it adapts to slower rates of growth.

China’s growth has been over stimulated since its 2008 RMB4 trillion (US$618 billion) stimulus package, which focused on physical capital investment. This helped build useful infrastructure, but there are too many new factories now with limited profit prospects. Investments make up a record 48 per cent of GDP, much higher than in other East Asian economies with overinvestment problems before the 1997-1998 financial crisis.

Money from excess savings is feeding a credit, asset and housing bubble. The authorities have tried to curb lending by increasing bank capital requirements or setting quotas, but this has been to little avail. Inflation is haunting the economy. China’s currency, pegged to the US dollar, has its hands tied: it cannot raise interest rates significantly enough to effectively fight inflation. Yet revaluation of the RMB contains risks, notably a shock to the financial system.

There are three scenarios. First, China could see, within the next two years or so, a financial meltdown followed by an extended period of low growth, say around 4 per cent, as China’s imbalances reveal themselves to be deep rooted. The second scenario would see a similar financial meltdown due to the bursting of the credit and housing bubble, followed by a swift recovery thanks to some financial and structural reforms. Growth would then sail along at 6–7 per cent. There could also be, as a third scenario, a ‘soft landing’ and a slow yet steady rebalancing of the economy with growth rates standing at around 7–8 per cent for another few years. The second scenario is the most plausible. The first scenario is a real possibility. The third is the best anyone could hope for.

It has become a cliché to say that China’s economy needs rebalancing. This rebalancing is already happening. Consumption is rising. Salaries are rising. Energy efficiency is improving. But the share of services raised only 2.5 per cent of total value added in 2005–2010, missing the 3 per cent target set in the last Five-Year Plan.

China’s stimulus package was meant to keep its economy afloat until the real engine of its growth — demand in the established big Western markets — got going again after the Great Recession. Europe remains China’s first export destination and the US second, but growth in the West remains stubbornly anaemic. Without the spur of Western demand, one can legitimately ask where China’s new factories will send their products. Although exports to other booming emerging markets have increased, these are not yet mature enough to make up for an eclipse of the West.

Direct international contamination resulting from a possible financial shock is not a major risk, as China’s financial system remains insulated from world financial markets. A crash in currently highly-bubbly Hong Kong however, where many big Chinese conglomerates raise money, could have important global ripple effects.

The first major effect to expect is a significant drop in commodity prices. This will affect the world’s commodity exporters in the emerging world and force them to go back to the drawing board to build more sustainable growth strategies involving less resource dependence. The second effect will be a slow-down in capital goods exports from industrialised nations, notably Germany, currently the only engine of growth in Europe.

Europe and the US are still too narrowly focussed on lobbying China over its undervalued currency and global imbalances. It is the Chinese authorities themselves that will decide soon enough when to end an exchange rate policy that no longer serves them well. As China’s wealth grows, trade between it and the US and EU will increasingly be based on product quality and diversity. Policy based upon this assumption is likely to make more sense in dealing with China.

The US and Europe have also pumped a lot of money into their economies. This will be a drag on growth. While the latter wind down their deficits and debts, devising a competitiveness strategy that involves China would be advisable. The strategy could focus on constructive work with Chinese authorities on product standards, notably environmental ones. It could also contribute to Chinese reforms to improve its investment climate and allow more Western investment in services (like banking, telecommunications, environmental services and higher education). A final issue such a strategy could address is getting rid of the kind of Western protectionism that targets China’s declining cheap-labour-intensive exports. This includes the vexing looser-than-average anti-dumping standards the EU currently applies to China because it does not recognise China as a market economy. According to WTO rules, this allows the EU to be more lax in its criteria to determine dumping.

Iana Dreyer is an independent analyst based in Paris. She is currently working with the European Union Institute for Security Studies on a global political and economic forecasting project.