A big economic slump has started in China as predicted. The rest of the world has came to know about it through none other than Chinese President Xi Jinping and Prime Minister Li Keqiang.

They disclosed to the world a steep rise in short-term interest rates, falling exports and a slump in the nation’s economic growth — undesirable facts and figures that those in power in Beijing would have concealed in the past.

This is because the Xi-Li leadership has realized that the Chinese economy is in such dire straits that any further deterioration would cause a serious global impact. How should the whole world, including Japan, respond to this alarm?

Unusual things are happening in the Chinese economy. Short-term interest rates shot up in the Shanghai interbank market in late June due to the fear of bankruptcy of certain banks. On the surface, the Chinese government and the People’s Bank of China took no action. Although no bank failures ensued, this alarmed the international community about serious problems in China’s financial system and the Chinese leadership’s readiness to cope with the situation with a stern attitude.

Even more worrisome is the fact that governments in many localities lower than the province level have become incapable of repaying huge debts, estimated to total between $1 trillion and $3 trillion. There is the possibility that these local governments could default on debts that amount to as much as three times the annual budget of Japan or, in the worst case, equivalent to 40 percent of China’s gross domestic product.

The accumulation of such enormous debts on the part of local governments is rooted in China’s growth mechanism. Since the 1990s, the achievements of local Communist Party leaders have been assessed on the basis of the economic growth rates in the areas they were assigned to. This is because, under the reform and opening policy pursued by Deng Xiaoping, the paramount leader of China from 1978 to 1992, it was thought that growth solved every problem.

This led many local party leaders to push large infrastructure construction projects that could produce results in a short time. Because there was a limit to the amount of money local governments could borrow from banks, they created companies that would build roads, port facilities, office buildings, etc.

With the guarantee provided by local governments, these companies borrowed money and built infrastructure whose earning power was small. It is inevitable that they would become unable to pay back the mounting debts. The Communist Party officials who initiated those projects moved to new jobs in two to three years, thus passing the responsibility on to their successors.

The money poured into these local projects came not only from banks but also from major state-run enterprises and investments funds run by people called “Princelings” or the “Crown Prince Party,” who were the descendants of prominent and influential senior Communist Party officials. These institutions thought that there was little risk in investing in such projects because they thought that the central government would not dare allow local governments and banks to fail.

They were also confident that should Beijing fail to take proper actions, state-run firms and “Princelings” would flex their political muscles to influence the central leadership to favor them.

In reality, however, neither the central leadership nor the central bank intervened. Eventually, the People’s Bank of China poured money into the market and short-term interest rates came down to a near normal level. The market was shocked and the whole world came to realize that China’s growth mechanism has started to collapse.

Another surprise move coming from the Chinese leadership is the way in which key statistics are now announced with greater accuracy than in the past.

Since the 1990s, and especially during the past two years, much doubt has been cast on the credibility of official figures. The competitiveness of Chinese manufacturers has been lowered due to a stronger yuan and rise of wages. This is testified to by the fact that one Japanese maker after another has shifted their production bases from China to other countries such as Vietnam, Cambodia, the Philippines and Bangladesh.

But Chinese statistics show that China’s exports recorded a double-digit growth through May 2013.

Lately the Chinese government announced that exports in June fell (3.1 percent) from a year earlier and that the economic growth rate during the second quarter of this year stood at 7.5 percent, down from 7.7 percent in the first quarter.

The announcement of these unfavorable statistics, will undoubtedly have a negative impact on investments from abroad, shows that the Xi-Li leadership is ready to carry out perestroika (rebuilding) and glasnost (making information public), as pursued by Mikhail Gorbachev of the Soviet Union in the late 1980s, in the economic field.

There is, however, the risk of Xi and Li facing the same fate as Gorbachev, who was fiercely attacked by conservatives and deserted by ordinary citizens.

Since coming to power, Xi and Li have started to try to accomplish two big tasks — restoring financial discipline and normalizing statistics — during the next 10 years in office. Their efforts resemble those of Prime Minister Zhu Rongji, who put his life on the line to reform state-owned enterprises in the late 1990s and can be characterized as the second stage of the reform under Zhu.

The difference since the days of Zhu is that China has become the No. 2 economy of the world and an engine of the global economy and that any failure on the part of Xi and Li would cause a massive tsunami that would devastate the world economy.

That tsunami would comprise three big waves: (1) evaporation of demand, (2) flooding of the world market with excess products from China and (3) spread of a financial crisis.

China consumes 35 percent of the world’s total iron and steel products, 45 percent of cement, 30 to 40 percent of home electric appliances and 23 percent of automobiles. If China’s demand for these products falls by 30 percent, global demand would drop by 10 to 15 percent, negatively impacting employment and wages in the United States, Europe and Japan. This would cool down consumer sentiment, decrease demand and reduce capital investment and demand for construction industry. This chain reaction could cause a Lehman Brothers-like shock.

Such impact would not be limited to the manufacturing sector because China is a leading purchaser of raw materials such as iron ore, copper, coal, crude oil and liquefied natural gas. Any sharp decline in China’s demand for these raw materials would deal a big blow to supplier nations such as Brazil, Australia, Canada, Indonesia and African countries.

China is not only a great consumer but also a leading manufacturer and exporter of finished goods. Other countries are suffering from Chinese exports sold below cost, notably iron and steel products and photovoltaic panels. If China’s demand drops, its surplus productive power will be directed at the global market, flooding it with low-cost products exported below cost. Even if factories operate in the red, Chinese enterprise, local governments and banks can accept it because it helps to maintain employment.

It is hard to predict what the Chinese shock in the financial sector will be like. Especially since the failure of the Guangdong International Trust and Investment Corp. and other financial institutions in the late 1990s, foreign banks have stopped lending to Chinese local governments and their affiliated financial companies. This may reduce the chances of foreign lenders getting hit by bad debts.

If Chinese banks go under, there is the possibility that financial turmoil will spread as bad debts form in the global market and enterprises that received loans from such banks go bankrupt.

Because the real situation of the Chinese economy is hard to see, it is impossible to predict the impact of the massive tsunami that could happen as a result of the reform efforts by Xi and Li, because not everything is made clearly known about the Chinese economy. This is ominous.

One thing is certain. There is no entity today that has enough energy to rescue the global economy from a collapse that might be triggered by China.

Expectations may mount for Japan. But Japan simply is not in a position to create new demand because its state finances are in a more serious situation than China’s.

The world economy that has lost China as its engine may well be drifting in the midst of a massive tsunami.

This is an abridged translation of an article from the August issue of Sentaku, a monthly magazine covering Japanese political, social and economic scenes.

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