The year 2016 started with a bang in China, but unfortunately, not with traditional firecrackers. Instead, economic data showing the 10th-straight month of slowing domestic manufacturing sent China’s stock markets into a downward spiral, triggering the market’s newly instituted circuit breakers and shutting down trading on January 4 and again on January 7. The Shanghai Composite Index dropped 6.9% on January 4, triggering a worldwide selloff and a dour start to the year in global equity markets. On January 7, stocks dropped by more than 7% after just 29 minutes of trading.

In addition to jitters about the domestic economy, says Marshall Meyer, an emeritus professor of management at Wharton, the “perpetual low level conflict in the Mideast” is rattling China. “Disruption of energy resources in China poses real difficulties for them and tells you where their real Achilles heel lies.”

With that stunning debut, in many ways China’s economic outlook in 2016 might not be so difficult to predict. The forecast calls for continuing slowdown — with the Chinese central government likely to declare an official GDP target of around 6.5% for the New Year, down from around 7.5% for 2015. The government is likely to announce actual GDP growth for the old year at 6.8%, according to experts, while the International Monetary Fund anticipates 6.3% for 2016.

But despite the overall trajectory, in many other respects, China’s 2016 economic outlook is entirely unpredictable — perhaps more so than at any other time in recent memory, say Wharton and other experts. “Uncertainty is the watchword for investors, developers or anyone doing business in China in 2016,” says Minyuan Zhao, a management professor at Wharton. “Of course, slowdown is the biggest theme. But after 30 years of fast growth, no one should be surprised by that, especially with China’s demographic change [to an aging population] and over-investment since the 2008 financial crisis.”

The X Factor

Instead, the X factor is the outlook for government policy, Zhao adds: “We’d like to see with more clarity where policy is going and how the general business environment will shake out. Difficult reforms, which investors have been waiting on for a long time, have not really materialized. They include whether state-owned enterprise (SOE) and financial market reforms will happen and if yes, in which direction. The market has had no consensus yet where the economy is going in 2016 … in terms of policies, or basically, the future business landscape for managers or investors.”

So far, Chinese officials “are walking a fine line and doing well, but the risks are on the downside if the slowdown in industry gets worse and spills out to other sectors.” –David Dollar

As China shifts from three decades of speedy growth built upon manufacturing, investment and export prowess to an era of slower growth based upon domestic consumption, private-sector entrepreneurship, innovation and services, clarity about the new rules of the road can help with a smoother transition, say experts. “From a managers’ perspective, top questions involve industrial policies — what is allowed and what is not, who can join and who cannot,” explains Zhao. “For most managers, it’s better to see a clear line. For example, in the financial world, initial public offerings have been put off, put on and then off again. It’s helpful to have some clarity, so you can look three to five years in the future to know what you’re working towards. Clarity and certainty allow managers and investors to make long-term plans.”

But it is unclear to what extent and at what pace the government will adopt reforms officials have promised to help the economy evolve from a state-directed system into a more market-driven one. Too fast a transition risks the shuttering of unprofitable state-backed and other enterprises in bloated sectors, chancing widespread unemployment and social unrest.

A disorderly and precipitous economic slowdown in China could also plunge other economies around the world into a downward spin. “Even more important than a structural shift from manufacturing to services, you need a certain amount of growth to sustain reasonable tightness of the labor market,” says Pieter Bottelier, an adjunct professor of China studies at Johns Hopkins School of Advanced International Studies (SAIS) in Washington, D.C.

According to David Dollar, a senior fellow at the foreign policy and global economy and development programs at the Brookings Institution in Washington, D.C., so far, Chinese officials “are walking a fine line and doing well, but the risks are on the downside if the slowdown in industry gets worse and spills out to other sectors. What global markets are worried about is a more serious slowdown that’s bad for China and bad for the world economy.”

Adds Z. John Zhang, Wharton marketing professor and director of the Penn Wharton China Center, “In the end, it’s hard to tell how China’s economic challenges and the government’s determination to meet those challenges will play out.”

Glimpse of the Market at Play

Indeed, allowing market forces greater sway means China’s economic managers may lose some control over the largely orderly soft landing they’ve been able to engineer so far. The summer of 2015 provides a glimpse: Starting in late 2014, the government began opening up major Chinese stock markets to foreign investors and encouraging domestic investors to enter the markets. Chinese stock exchanges peaked on June 12, 2015, more than doubling over the previous 12 months. But then the Shanghai composite index fell 28% between June 12 and July 2, while the Shenzhen Composite Index lost a third of its value.

“Credit rollovers are bad and are creating a new supply of non-performing loans that have to be dealt with eventually, but they’re not as bad as closing enterprises and layoffs.” –Pieter Bottelier

Though the People’s Bank of China (PBOC) then cut interest rates, and the government undertook numerous other market-propping steps, including suspending IPOs, requesting brokerage firms and insurance companies to put more money into the markets, and launching investigations of market manipulation by securities regulators and others, market volatility continued. On August 24, the Shanghai Composite Index suffered its biggest one-day drop in almost a decade, losing about 40% in value from its mid-June peak.

Exacerbating this scenario was a devaluation of the yuan on August 11 that took global markets by surprise. On that day, the PBOC cut the yuan’s daily reference rate by 1.9%, prompting the currency’s biggest one-day drop since 1994. The devaluation sent global stock markets tumbling, as investors interpreted the move as a salvo in a new round of global currency wars. On January 7, the PBOC shook the markets by setting the official midpoint rate on the yuan to 0.5% weaker, at 6.5646 per dollar — its lowest since March 2011, Reuters reported.

Closer to reality, the devaluation was an effort to allow the market greater say in setting exchange rates to position the yuan for acceptance by the International Monetary Fund (IMF) into the basket of currencies that compose the IMF’s Special Drawing Rights (SDR’s) reserve currency. Indeed, the IMF did go on to accept the yuan as part of the SDR basket in December, a goal long pursued by China. The PBOC also since moved to a new system for setting the yuan’s exchange rate versus a basket of currencies, not just the dollar.

China’s foray into financial liberalization provides a reminder that government managers can no longer expect to contain market reactions. “That exchange rate decision [of August 11] compounded market nervousness about the Party’s ability to manage the economy, because it screwed up badly on the exchange markets in June and July,” says Bottelier. Says William Adams, vice president and international economist at PNC Financial in Pittsburgh: “As China takes dramatic steps to liberalize its financial system and open borders to international flows of capital, those moves potentially introduce new sources of volatility and uncertainty to the Chinese economy. Alternatively, the free flow of capital means that Chinese financial volatility could potentially trigger episodes of global financial volatility, too.”

Adams expects further depreciation of the yuan in 2016. Most currencies have depreciated more than 20% against the dollar since mid-2014, while the yuan has depreciated a little less than 5%, he notes. “Market forces are arguing for a weaker yuan,” especially when the Chinese economy is slowing and the yuan is still relatively strong to the yen, euro and other non-dollar currencies, he says. In turn, a weaker yuan would help Chinese exports and stem a long-running slide in producer prices, he adds.

Crisis Ahead in 2016?

Even with so many stresses in the transitioning Chinese economy, many experts say the potential for a crisis in either the financial markets or in the real economy in 2016 seem minimal. “So many potential crises are things we’ve been talking about for years,” says Adams. “But the crises haven’t happened yet, including risks from a property market collapse, overcapacity in industry, and corporate and local government debt overhang. It’s hard to say why 2016 would be different from 2015, though the prospect can’t be entirely discounted.”

One important sector to watch is real estate, a key question governing how far GDP will fall, says Bottelier: “There’s a tremendous supply overhang in many cities, dating back to the 2008-2010 stimulus program, which vastly over-expanded credit for real estate development. Many thousands of developers have since scaled back significantly on investment in new floor space, which has a depressing effect on raw materials, factories that make doors and windows, furniture for new apartments and the like. But normalization between supply and demand in the property sector should come in the next 12 to 18 months.”

“Though some industries suffer from overcapacity, there’s still a significant shortage in health care and education…. The moment you show the direction, a lot of resources and energy in the country will come forward.” –Minyuan Zhao

Likewise, the unwinding of industrial overcapacity in the manufacturing sectors continues to loom. Yet, says Bottelier: “We haven’t seen the level of bankruptcy that you’d expect in a normal market. Bankruptcies, especially at the local level, have largely been avoided because of loan rollovers. Credit rollovers are bad and are creating a new supply of non-performing loans that have to be dealt with eventually, but they’re not as bad as closing enterprises and layoffs.” Wharton’s Zhao agrees, noting that “it’s a ticking time bomb, but does anyone want to bear the consequence of street protests? This is no different from the U.S. when policy makers kick the can down the road time and again.”

The Good News

While China’s manufacturing and real estate sectors undergo a painful restructuring, “the good news is that services and consumption are growing well, the labor market is fairly tight, and wages and household incomes are going up,” says Brookings’ Dollar. “The duality where income and consumption are growing well, while industry is in trouble, is a little surprising. One risk in 2016 is those problems in industry get worse, causing firms to close, putting workers out of work and adversely affecting wages and consumption growth. But if they can maintain this situation of healthy growth in consumption and services, that’s a good growth path in China.”

Wharton’s Zhao agrees: “There’s still a lot of pent-up energy in China. The consumer market and services industry are going strong, and there’s a lot of discussion on the transition from ‘Made in China’ to ‘Made for China’ to take advantage of the large market. Though some industries suffer from overcapacity, there’s still a significant shortage in health care, education and all that. The moment you show the direction, a lot of resources and energy in the country will come forward.”

PNC’s Adams points out that China experienced the fastest monthly retail sales growth in November for the year. Online retail giant Alibaba reported 60% year-over-year sales growth on November 11, Singles Day, a big retail event in China. “Discretionary spending in the consumer sector can’t be in that much trouble,” he says. “There are signs of a shift to a more consumer-driven economy, which sooner or later, will affect income growth.” Indeed, according to China’s National Bureau of Statistics, national per capita disposable income, adjusted for inflation, rose 7.7% year-over-year in the first three quarters of 2015.

SAIS’s Bottelier agrees: “In spite of a serious economic slowdown, wages in most of the labor market, from unskilled to semi-skilled, continue to rise,” supporting consumer spending and the rise of a middle class. The shift from manufacturing to services, which supports greater employment, and the slowing supply of migrant labor in relation to continued demand help explain the phenomenon, he says. In addition, a boom in domestic value-added, high-end manufacturing is supporting higher paychecks, he adds.

With the Chinese economic outlook still uncertain and a rising interest rate environment in the U.S., many wealthy Chinese are sending their money — and their children — abroad. Says Wharton’s Zhao: “At this point, uncertainty is driving both talent and money to safe havens.” But, she adds: “It’s not necessarily a trend going forward if China can implement clear policies on investment and reform. I know many people put their money overseas to buy real estate in New York and California, and send their kids to college in the U.S. They don’t see these as the best investments, because they know better how to invest in China.”

Indeed, says Bottelier: “Economic rebalancing is major theme that will take many years to begin to work. It’s a very difficult long-term process that’s bound to be misunderstood and misinterpreted by many with a shorter-term horizon. If they can get through the next 12 to 18 months without major problems in the labor or property markets, the benefits of rebalancing will begin to be more visible.”

In the end, says Wharton’s Zhang, “You cannot just look at GDP. It means something but not everything. You can have bad, non-performing GDP, or you can have good GDP.” Presumably, good GDP lies ahead if both Chinese policy makers and citizens can make build the foundations of more consumer-led growth.