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China’s decreasing growth rate translates into falling inflation rates, something that concerns the European Central Bank.

CHINA DAILY/Reuters

What's scarier if you are an investor with an over-the-horizon view: The Ukraine crisis or the economic slowdown in China?

Blinded by the media glare, you would probably pick the Ukraine crisis, which began last month with the ousting of the country's corrupt, pro-Moscow president and may have reached its climax this week with Russia's annexation of Crimea – Vladimir Putin's Anschluss moment.

But maybe the climax has yet to come. Investors in North America and the European Union are duly worried that the sanctions designed to punish Mr. Putin and his cronies will evolve into full-blown trade, investment and banking sanctions that would severely damage the Russian economy, the world's eighth largest. Broad, punitive sanctions could in turn trigger retaliatory sanctions that could damage the fragile EU economy (less so the U.S. economy).

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We got a hint of the possible mess to come on Friday, when Russian Prime Minister Dmitry Medvedev threatened to raise the price that Ukraine pays for natural gas and sue the country for $11-billion (U.S.) in arrears to Gazprom, the Russian state gas exporter. Russia supplies about a quarter of the EU's gas. Imagine if it were to reduce or eliminate supplies to the EU. There would be an instant energy crisis, with both sides racing each other into recession.

While sanctions can work well – Iran comes to mind – they tend to work less well when the sparring economies are closely linked, as Russia and the EU are. Killer sanctions are unlikely, although all bets are off if a shooting war starts inside Ukraine.

But as Ukraine dominates the headlines, it is the slow evaporation of China's heady growth rates that is the real story. What happens in Ukraine matters in the short term. What happens in China matters a lot more in the short, medium and long terms. More reports and evidence come almost every day that the world's second-largest economy is no longer pursuing growth at any cost. In 2007, the year before the Lehman Bros.-inspired financial crisis, China's gross domestic product expanded by 14 per cent. Last year it was 7.7 per cent. This week, Goldman Sachs lowered its 2014 China GDP forecast to 7.3 per cent from 7.6 per cent.

Even that figure may be optimistic. Some economists think this year's true growth figure will be 6.5 per cent, although any prediction is a mix of genuine data, extrapolation and voodoo. As good an indication of any comes from the Merrill Lynch-Bank of America China LEAP index. It measures seven components that, taken together, give a snapshot of broad economic activity – power, steel and cement production, auto sales, housing starts, railway cargo turnover and medium- to long-term loans. The index peaked in late 2009 with 12-per-cent year-on-year growth. The latest reading was less than 5 per cent.

Growth of 5 to 7 per cent would be a dream figure in North America or the EU, especially in the EU, which is barely out of recession with a 10.8-per-cent jobless rate. So what does it matter that China's growth rates are falling if the GDP growth is still firmly in positive territory?

It matters a lot. In 2012, China's growth accounted for 60 per cent of global growth. As growth comes down, the global economy will need to find a new economic driver, probably a futile process. Slowing Chinese growth translates into falling inflation rates. The European Central Bank is already in a low-grade panic about falling inflation – it's well below the 2-per-cent target in the euro zone – leading to predictions that a version of the Federal Reserve-style quantitative easing is coming.

A slowing Chinese economy is especially bad for Canada, which specializes in digging minerals out of the ground and exporting them. The "stronger-for-longer" commodity cycle, and the massive resources investments that went with it, was based largely on never-ending growth in China. Things that are too good to be true generally are too good to be true. The C-buck is falling along with inflation rates. Writedowns are walloping the mining industry in Canada and elsewhere. Commodity prices could keep falling. A small decrease in demand can translate into a big decrease in price. In the past month alone, copper prices have fallen 10 per cent.

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Investors playing the growth game may be in for more bad news. That's because the credit bubble has sent China's public and private debt soaring. In 2007, overall Chinese debt was about 150 per cent of GDP; today it's about 220 per cent. To bring down borrowing before it becomes unsustainable, Chinese regulators will have to clamp down on the vast "shadow bank" system (trust companies, insurance firms, leasing companies and the like) that has pumped oceans of credit into the economy. Defaults will happen, and in fact are happening. The outcome can only be ever-slower growth rates.

Ukraine and the related sanctions against Russia are not what the world needs. The new Cold War could add momentum to the emerging-market selloff. But it's a sideshow compared to the big show, which is China's growth rates going from the extraordinary to the ordinary. Portfolios built on the belief that China is a perpetual economic miracle are bound to get hurt.

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