Investors have been agonizing over how big a threat China poses to the global economy, but they may be looking in the wrong place.
China's stock market has tumbled following stratospheric gains that peaked in June, while economic data indicate that the nation is likely to fall short of its 7 percent growth expectation.
What matters more than either metric, though, is China's plan for retooling its economy, from one focused on industrial and housing growth atop piles of debt to consumer-based gains in consumption and investments in the stock market.
How they go about achieving that strategy, in part by reducing the amount of foreign debt purchases, is what could have more impact than anything else.
"There is a strong case to be made that it is neither the selloff in Chinese stocks nor weakness in the currency that matters the most," George Saravelos, forex strategist at Deutsche Bank, said in a note to clients. "Instead, it is what is happening to China's FX reserves and what this means for global liquidity."
In 2003, China began a "reserve accumulation" program that amounted to the equivalent of $4 trillion, which exceeds even the $3.7 trillion or so in a similar quantitative easing program the Federal Reserve initiated in 2008 and ended in October 2014.
During China's massive QE run, it increased its U.S. Treasury holdings by a factor of 10—from $120.7 billion in 2003 to $1.27 trillion in June 2015, according to the latest U.S. Treasury data. All that buying pushed it past Japan in the global lead for holders of American debt, while keeping U.S. yields low and producing, except for the financial crisis, a flat yield curve.
However, circumstances are changing. China has devalued its currency, triggering capital outflows of $200 billion in August alone, according to one estimate Saravelos cited, and concerns of instability. China responded by subsequently defending the yuan, in part by selling its foreign currency reserves and, importantly, "reducing its ownership of global fixed income assets," Saravelos said.
"The (People's Bank of China's) actions are equivalent to an unwind of QE, or in other words quantitative tightening," he said.
Saravelos said the world's biggest worry is "that QT has much more to go."
Preventing China's tightening from becoming a more severe problem would require any of three potential solutions, he said: The PBOC would need to embark on an aggressive easing program; other central banks would have to pick up the slack; or more confidence would need to emerge in China's overall growth picture, stemming capital outflows.
"Either way, it is hard to become very optimistic on global risk appetite until a solution is found to China's evolving QT," Saravelos said.
To be sure, not everyone is as worried about China, on the belief that its fundamentals are still strong enough to support growth and that it has adequate policy tools to deal with the issues it faces. After a scare earlier this week induced in significant part by China fears, U.S. stocks snap backed violently Wednesday and Thursday, taking the out of 10 percent correction mode.
Goldman Sachs economists Noah Weisberger and Sharon Yin believe China's weakness will be limited to within its borders and won't cause major global problems.
"Policymakers seem focused on the need for a domestic rebalancing that will likely entail a prolonged period of slower growth as the debt overhang is worked off," the Goldman team wrote in a report for clients. "From here, we envisage a manageable slowdown, with policymakers expected to provide a near-term boost to help smooth out bumps along the way."
Solving the problem is vital not only for the nation but also for a world in which China currently accounts for 16 percent of total gross domestic product and is likely to replace the U.S. as the No. 1 economy in a matter of just a few years.
"While significant backstops in China certainly exist in theory, internal pressures, growth worries and market sentiment may still get worse before they get better," Weisberger and Yin cautioned. "For now, worries are centered on growth, which, despite aggressive policy ... has yet to stabilize."