China’s stock markets and currency recently incurred precipitous declines. These problems are reflective of much bigger issues that have allowed many Chinese to confuse a rising stock market with a healthy one — and an economic system with a sustainable one. Moving forward, China’s brand of one-party capitalism will continue to incur inescapable difficulties. What does this mean for the future of China? And how does it impact the United States?

Currency Volatility

On August 11, 2015, the Chinese renminbi, also known as the yuan, tumbled 1.9 percent against the dollar — the largest one day decline in decades. China indicated it was allowing market forces to play a greater role in determining the yuan’s value — part of a larger effort toward economic reform. If true, it also conforms with China’s desire to make the renminbi a reserve currency like the U.S. dollar, British pound, European euro and Japanese yen. And China’s goal of getting the renminbi included in the IMF’s reserve currency basket is a symbol of power.

Others say China was responding to deep seated problems in its economy and attempting to boost exports, which have become less expensive due to its currency devaluation. Both answers may be correct.

In July 2005, when China pegged its exchange rate to a fixed basket of currencies, one U.S. dollar could buy 8.28 renminbi. Years later on August 10, 2015, one dollar could only buy 6.19, reflecting a stronger Chinese yuan. By August 12, the value had dropped to 6.31 — but still considerably higher than in past years. Since this writing, the yuan hasn’t fluctuated much.

This value reduction is relatively small when compared to the depreciation of other currencies, like the euro, which dropped approximately 18 percent against the dollar over the past year, and the Japanese yen, which dropped about 22 percent. Nevertheless, Chinese currency volatility has encouraged capital flight and discouraged investment and consumer spending in the Middle Kingdom.

The leadership’s ability to deliver — which is the basis for its legitimacy — appears to be in question to a greater extent.

Since China has been trying to stimulate consumer spending, which only represents 35 percent of its gross domestic product (by contrast U.S. consumer spending represents 70 percent), the devaluation has made this goal more difficult to achieve.

Since the yuan has been pegged to a basket of currencies seemingly dominated by the U.S. dollar, as the greenback rose so too has the yuan relative to third country currencies. This has made Chinese exports and manufacturing operations more expensive. By devaluing the yuan against the dollar, the Chinese currency has become more fairly valued.

What Goes Up Must Come Down

Prior to China’s currency devaluation, its Shanghai and Shenzhen Stock Exchanges, two of three major exchanges in China, experienced precipitous declines beginning in early June. In turn, the Chinese government suspended trading of large numbers of shares and implemented a series of measures to stem the tide.

These reportedly included cutting interest rates and reducing reserve requirements on banks to stimulate lending, relaxing rules on home mortgage borrowing to encourage stock purchases, and pledging billions to state-controlled banks to lend to projects like construction of highways, municipal office and commercial buildings, and residential housing. The government also has censored reporting of stock market news and even arrested journalists to keep a lid on negative press.

Overall, however, stock values still remain relatively high. On September 8, 2015, Brian Wesbury, Chief Economist at First Trust Portfolios said, “The Chinese stock market has fallen sharply in recent months, but the Shanghai Composite stock index is only down 2 percent year-to-date and is still up 36.3 percent from 12 months ago.” Nevertheless, the Chinese currency devaluation and stock market dive are a reflection of bigger issues.

Problems Ahead

With Chinese economic growth slowing, fewer job opportunities are likely to emerge in the years ahead. As a result, President Xi and the communist leadership likely fear instability to a greater extent than in the past. To head off potential social unrest, President Xi has implemented new restrictions on social freedoms, the media, lawyers and foreign non-profits, and reportedly placed police units at major internet companies to monitor and censor traffic.

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Likely designed to further strengthen the grip of the President, in August, Chinese state media reportedly issued a warning to retired officials to stay out of politics and not misuse their networks and influence.

Due to potential problems ahead, the Chinese leadership has placed a laser-like focus on job creation. But its capacity to achieve real success is in doubt. And the level of confidence in the leadership and its ability to deliver — which is the basis for its legitimacy — appears to be in question to a greater extent by ordinary citizens.

This concern has been compounded by the recent stock market crash that hurt many retail stock investors who have few opportunities to grow their savings and went “all in.” Plus, the government’s cheerleading efforts to promote stock buying is another factor driving mistrust.

Furthermore, a series of explosions in early August in the Chinese port of Tianjin that killed over one hundred people has revealed severe negligence, disregard for regulations, and corruption at senior government levels. This, too, has cast greater doubt on the government’s ability to provide a higher standard of living.

Is the System Sustainable?

For years, China has engaged in a process that involves the implementation of economic reforms designed to move the country away from a state managed system to a more market oriented one, and from an export and investment driven model to a consumer driven one. This is a necessary path that China has acknowledged it needs to follow. And there is no mystery why.

History has repeatedly demonstrated that a market based economy is significantly more effective at allocating resources and boosting productivity than one where a group of leaders make major economic decisions. Importantly, when the state rather than the market attempts to determine economic outcomes, as it does in China to a large extent, the results aren’t always what were anticipated.

This can be seen in China’s ghost cities where the government instructed the state-owned banks to lend to state-owned construction companies to build commercial real estate. This process creates economic growth even though many urban areas remain vacant.

Another example is the performance of China’s state-owned enterprises. Reported by the Chinese Ministry of Finance, Chinese state-owned enterprises number more than 100,000 with assets of approximately $13 trillion. They typically are less productive and use capital less efficiently than private firms.

Plus, the returns of state-owned enterprises are poor and a major reason why the Chinese economy is underperforming, says the Paulson Institute, a think tank with offices in the United States and China. This creates a drag on economic output at a time when China is shifting onto a slower growth trajectory, the Paulson Institute notes.

China is walking the line in a distinctly Chinese way. But this could be more dangerous than a high wire act.

With an understanding of this reality, Chinese President Xi Jinping and members of the leadership continue to pressure state-owned enterprises to rely less on subsidies and more on the market. But with lower economic growth projected and social stability becoming a greater concern, the goal of weaning state-owned enterprises off the state had slowed or crawled to a halt.

With increasing pressure from Chinese citizens to advance reforms, and resistance from conservative party elites, President Xi has had to cope with many challenges. One explanation for his high profile anticorruption campaign — which in 2013 alone involved 172,000 corruption cases and 182,000 officials, the Brookings Institution reports — is an attempt to eliminate possible opposition to reform efforts and to consolidate his power base.

History tells us that when countries liberalize their markets, it’s only a matter of time before their political systems follow. The adage “open markets open minds” has repeatedly proven true. Look no further than the former Soviet Union to understand what occurs when the flow of information, trade and investment enter authoritarian states.

Understanding this reality, the communist party, which does not wish to share power, is walking the line in a distinctly Chinese way and trying not to repeat the mistakes of the former Soviet Union. But this could be more dangerous than a high wire act.

In addition, demographic problems are adding weight. China’s one-child policy introduced in 1979 to alleviate social, economic and environmental problems now is causing many unintended consequences. And the recent relaxation of the law is unlikely to undo demographic problems ahead.

Reported in The Wall Street Journal, the United Nations Population Division indicates that each successive Chinese generation will shrink by 25 percent. A decreasing workforce, which is already causing labor shortages and skill deficits, will be required to support an increasingly elderly population.

The Impact on the United States

Although China is under a great deal of pressure, it’s important not to underestimate its strengths. With nearly $4 trillion in reserve, China is unlikely to implode and more likely to regain its footing — although it travels on a slippery slope.

As news emerged of Chinese economic problems — which translates into fewer U.S. exports to the Middle Kingdom — U.S. and global stock markets retreated. As the world’s second largest economy, it’s evident that what happens in China doesn’t stay in China.

But since the Chinese Shanghai and Shenzhen Stock Exchanges are not open to global investments, the damaged is limited. And although U.S. exports to China are significant, they only represent 0.7 percent of U.S. gross domestic product. Consequently, the fallout has been restricted and hopefully it will stay that way.

This article appeared in Global Impact, a Great American Insurance Group publication.