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Teetering Shenzhen property conglomerate China Evergrande is the Chinese economy in miniature. Both have operated for decades on the principle that it was worth borrowing to build, in Evergrande’s case mostly housing, in China’s case not just apartments, but roads, rail, airports and other infrastructure.

Evergrande’s business has run out of credit, in large part due to policy shifts by the Chinese government. Investors have watched in horror as its bonds, and those of other wobbly property developers, collapsed. China’s economic model has also run out of road, and the process of putting it on a new track is likely to bring more Evergrande-like mistakes.

We now have to contend with the short-term risks of spillovers from Evergrande while assessing the longer-term effects from the shift in China’s economic model. Both could have serious implications for the rest of the world.

The worst-case short-term impact from Evergrande would be that it prompts a domino of failures as finance flees from other Chinese property companies, housing and land prices crash, and Chinese savers find the empty apartments they invested in are worth less than they paid. Suppliers of concrete, steel, wire, pipes and other building materials would collapse, and unemployment soar. The global hit would start with countries that provide the coal, iron ore and other commodities China needs, such as Australia and Brazil, but wouldn’t stop there.

Meanwhile, financial contagion could come from failures of those who made concentrated bets on Chinese stocks or bonds, akin to Long-Term Capital Management’s 1998 collapse.

Western markets have shown little concern about such an awful outcome, because no one believes China will allow it. It is impossible to know what support China’s authoritarian regime will provide. The path of least resistance is to protect suppliers, home buyers, small investors and savers, at the expense of Evergrande management, lenders, institutional investors and, especially, foreign creditors. Evergrande should go to the wall pour encourager les autres, but China doesn’t want a systemwide crisis.

As to financial contagion, there is no way to know for sure, but there is no sign of it yet. Big banks do dumb things, as the multibillion-dollar losses from lending to Archegos Capital Management showed earlier this year. The U.S. system is more resilient than in 1998 or 2007, so any blowup by a hedge fund or a Chinese bank would have to be really big or interconnected to pose a threat.

Psychological contagion is more likely. International investors antsy about the high valuations of pretty much everything might refocus on risk, rather than reward, and pull back from stocks and riskier bonds. But with the cost of safety so high—guaranteed losses after inflation on government bonds and cash—it is even more expensive to seek security, which helps to support risky assets.

The long-term impact could be even more disruptive. China has tried repeatedly to rebalance its economy away from debt-driven construction toward consumption and service industries. It has had some success, but every time there is a slowdown, it returns to the tried-and-tested model of jacking up debt and investment to boost growth.

This time might be different, as President Xi Jinping has secured all the levers of state power; perhaps he is ready to accept slower economic growth as the price of it being more sustainable. Capital flight is hard too, after a clampdown on routes previously used to get money out of the country, and with Covid-19 restricting travel.

If China really is pushing back against unsustainable debt-driven growth, it faces a series of tricky problems as it remakes its economy. It will have to wean the population off the idea that empty apartments are a good vehicle to save money, without destroying everyone’s savings. It will have to persuade people that they should save less and spend more. It will have to reallocate vast numbers of workers and capital from real estate and the broader construction industry, which together make up about one-eighth of the economy, and together with suppliers probably account for more than a quarter of gross domestic product. And it will have to raise taxes to substitute for land sales as a source of finance. Worse, it will have to do all this while adding less debt and accepting a lower growth rate.

The model needs rebalancing, because it is unsustainable. China adopted the same if-you-build-it-they-will-come mantra as Kevin Costner in “Field of Dreams," but aging demographics and slowing urbanization mean “they" no longer come in such numbers.

Debt absolutely can’t keep rising at the rate of the past decade, either. China is one of only three countries to add nonfinancial debt amounting to more than 100% of GDP since 2011, according to the Bank for International Settlements (alongside Greece and Singapore, while Chinese territory Hong Kong has, too). It now has about the same level of debt-to-GDP as the U.S., despite a significantly less well developed financial system.

If China succeeds, it will mean less demand for the raw materials it has been importing, more demand for consumer goods, and, probably, a better balance of trade. For the rest of the world, that means lower prices for steel, copper and the energy that was going into cement, and less need for China to recycle dollars into Treasurys and other overseas holdings. But if China succeeds it also means less cheap Chinese labor and more Chinese consumption pushing up global demand, both of which are broadly inflationary.

History suggests it is exceptionally hard to navigate such shifts without mistakes, and China is so big that the shifts will need to be global, not merely domestic. It could be a bumpy few years.

China’s stop-start rebalancing hasn’t made much progress in the past few years, but it seems to me that Mr. Xi is more and more serious about it, quite apart from wanting to reassert controlover the private sector. As that rebalancing filters out into the rest of the world it will matter to all of us. Evergrande is a wake-up call.

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