Is China's miracle at an end?

China's stockmarkets have plunged and the central bank has cut interest rates to 4.6%

Updated: 
Is China's miracle at an end?

Chinese markets have been in turmoil. But does this signal trouble in the wider economy? Is it too heading for a crash? Matthew Partridge investigates.

What's going on?

Chinese stockmarkets have plunged – the benchmark Shanghai Composite Index is down around 40% from its peak in June (though still up 35% on a year ago). The Chinese government has also allowed the value of the yuan (its currency) to fall against the US dollar, while this week, the central bank, the People's Bank of China (PBOC), cut interest rates to 4.6%.

There were already plenty of signs that the Chinese economy was slowing, but the flurry of intervention has raised fears the economy is heading for a much bigger slowdown than expected, or a "hard landing". Indeed, UK think-tank Fathom Consulting believes this is already in motion, claiming in January that growth had slowed to just under 4%, significantly below the historical trend of around 8%.

Are these fears justified?

The official data suggest that the slowdown is very gradual, with the Chinese economy still growing at an annual rate of 7% in the second quarter of the year. Critics counter that the Chinese government regularly manipulates data to give the impression that growth is more stable than it really is, so survey data are a more reliable indicator (see box) – for example, the Caixin manufacturing purchasing managers' index (PMI) fell to 47.1 in August. That's the lowest level in more than six years, and well below the 50 level that indicates expansion.

The figures for new orders and employment were particularly gloomy. However, some unofficial surveys, such as the China Beige Book, suggest that the economy is performing relatively well. And Mark Williams of Capital Economics emphasises that "recent data have been more positive than the headlines might suggest, with large parts of the economy still looking strong". For instance, while the manufacturing sector is at a record low, the service sector PMI has hit an 11-month high.

What about the long run?

China is unquestionably going through a difficult period. Even the Chinese government accepts that growth will slow in the longer term as wages catch up with rates elsewhere, eliminating the cost advantage that Chinese firms currently enjoy. The country is attempting to move away from a model based on massive investment spending (on roads, railways, and the like) and exports, and towards a more "developed" model based on domestic consumption in an effort to avoid the "middle-income country trap" (where countries stagnate after they reach a certain income level).

As former UBS economist George Magnus puts it in Prospect, "It is doing so in a political environment which is designed to facilitate change but is at the same time complicating and stifling it. The upshot is likely to be a sustained economic slowdown to around 4% or 5% over the next couple of years." That in itself doesn't have to be a problem – clearly the country is growing from a larger base, so growth in absolute terms will still be far larger than it was in the past – "but no one knows what the transition will look like, how it will be managed, or what policy errors will be made along the way."

What can China's government do?

China has been continuing with economic and financial reforms in an effort to improve productivity. Williams even suggests that the recent slowdown could be evidence of the reforms having an impact – "the recent pattern of weakness in property construction and heavy industry set against strength in services is a positive sign that rebalancing towards a more sustainable growth model is underway".

Equally, the loosening of the yuan's peg to the US dollar might have been communicated poorly, but it does represent a modest shift to a more market-orientated exchange rate. And even if China's economy is stagnating rather than slowing, Beijing still has considerable fiscal and monetary room for manoeuvre. For instance, even after Tuesday's interest rate cut, the main benchmark rate stands at 4.6%, so it could be reduced still further. However, Beijing may have less room for manoeuvre than it seems. While the official national debt is 40% of GDP, it could be significantly higher – many local authorities have borrowed large sums of money, while many state banks have high levels of bad debt.

How will this affect the UK?

The fall in the Chinese stockmarket and impact on commodity prices has hit the mining-heavy FTSE 100 hard. There have also been concerns that falling Chinese demand could lead to renewed deflation. However, with the UK being a net importer of both natural materials and energy, lower prices will leave British consumers with more disposable income, potentially boosting consumer spending and growth in the longer run.

China's dubious statistics

China's statistics have long been the subject of criticism. While everyone agrees that China's economy has been growing very rapidly over the past 30 years, the official rate of growth has been suspiciously stable, even when its main trading partners have been enduring recessions. Even China's National Bureau of Statistics has admitted that it routinely adjusts regional statistics downwards because of concerns that local bureaucrats are exaggerating growth. However, experts disagree about the extent of the fakery.

Professor Harry Wu of the US-based research group The Conference Board suggests that GDP is actually about a third lower than stated levels, but work by the US Federal Reserve has suggested the figures are largely accurate. As a result, economists often use other data, such as vehicle sales, electricity usage and rail freight statistics to estimate short-term growth rates.

More on AOL Money:

Harsh lessons for China after dramatic week​

UK's economy growing but China turbulences could hit trade​

FTSE surges 200 points as China cuts interest rates​

The Worst For China's Economy May Not Come Until 2016