Bo Xilai (Feng Li/Getty Images)

Bo Xilai (Feng Li/Getty Images)

More than you probably realize, Canada's future prosperity rests on the outcome of a political thriller unfolding an ocean away.

This much we know. On March 15, one of the contenders to become China's president for the next decade, Bo Xilai, was sacked as the Communist Party boss for Chongqing, an inland megalopolis with a population roughly equal to Canada's. Not only that, he was kicked out of the 25-member Politburo and thus out of contention to join the nine-member standing committee-the executive body that really runs China-at the end of this year.

Not long after, Bo's wife, Gu Kailai, was charged with last November's suspected murder of a British businessman, Neil Heywood. Bo and Gu had been China's most potent power couple, offspring of revolutionary heroes and renowned for fighting organized crime. Their revival of Mao-era patriotic songs was a callback to the country's past-yet they had a son at Harvard known for driving a Ferrari.

The rest of the tale is hearsay: that a heavily indebted Heywood, a former family friend and fixer who had helped get Bo junior into Harrow (Heywood's prestigious alma mater in England) had demanded a bigger cut of a business deal; that he threatened to expose underhanded dealings by Gu if he didn't get it; that Bo's police chief, Wang Lijun, had confronted him over the alleged murder (the death was originally put down to alcohol poisoning), after which Wang sought asylum at an American consulate; that Gu had shown up at a police station in a People's Liberation Army major-general's uniform to announce that she was under special orders from Beijing to "protect" Comrade Wang; that the couple had plotted to assassinate Wang and came up with three separate storylines to avoid being implicated.

What we in the West definitely don't know is the current location of Bo or Wang, what repercussions will be felt by Bo's powerful allies in politics, business and the military (the Financial Times reported May 14 that Bo's mentor and standing committee member Zhou Yongkang had been relieved of his duties as head of China's police, courts and spy apparatus), and who is going to lead China for the next 10 years, let alone what their policy leanings may be. Whether the stories about the Bo family are true or the embellishments of political rivals, neither scenario inspires confidence in China's leadership and system of governance. There is little interest in trying to expose the objective truth, exonerate the innocent or punish the guilty-whether justice will be served doesn't even enter into the equation.

Indeed, this story of intrigue might be just a salacious distraction were it not taking place at the top of the ruling class of China, which will likely be the world's largest economy by the end of the decade and a place upon which Canada's fortunes increasingly hinge. Where Canada's economy used to move in lockstep with that of the United States, today it is China that most strongly influences things like commodity prices and the value of the Canadian dollar. In the aggregate, that ought to be good for Canada, especially when you compare the robust economic growth projections in China versus the anemic U.S. But that greater opportunity comes with greater risk. To the degree that we produce and sell commodities that China wants to buy, we will likely come out ahead in the long run. Amid the uncertainties around China's political succession, its bubblicious housing market, its unaccountable state-owned enterprises and its aging population, we may be in for a bumpy ride.

"We need to know what we're getting into," warns Wendy Dobson, a professor at the Rotman School of Management at the University of Toronto who has written extensively on China. Not that we have a choice; our increased exposure to emerging-market economies is inevitable, she says. China's power struggles are no longer the subject of idle curiosity, but a potential threat to our well being.

For almost a decade, economists have noted the growing influence of China over Canada's economic fortunes. In a 2007 report, " Not Dutch Disease, it's China Syndrome ," Statistics Canada macroeconomic analyst Ryan Macdonald demonstrated how the integration of emerging economies, most notably China, into the global economy played a leading role in Canada's improving terms of trade since 2003. What was happening 10,000 kilometres away boosted demand for commodities including oil, minerals and food. It was not, as politicians including Thomas Mulcair and Dalton McGuinty have argued, a case of "Dutch disease"-that implies the discovery of a low-cost resource like the Netherlands' natural gas finds of the 1960s that ended up rendering the country's other industries uncompetitive-but rather the increased demand for things we already produced that was reconfiguring the Canadian economy. It didn't matter that Canada did not actually export many of these products, including oil, to China; demand growth there affected prices worldwide.

This rise in commodity receipts created a cascade of mostly beneficial effects for Canada. Resource industries enjoyed higher profits and a wave of investment. Real personal incomes rose, which in turn created higher domestic demand for goods and services. Rising demand in Canada meant increased employment in service industries and certain manufacturing industries, higher government revenues and spending. The increased manufacturing capacity in China and other emerging markets brought a decline in the price of most imported consumer goods. This, combined with a rising Canadian dollar, also made it harder for Canadian manufacturers of consumer products to compete. But total manufacturing output in Canada actually rose 1.3% between 2003 and 2006, Macdonald noted. On balance, Canada was richer as a result.

Since that report came out, we can count another upside to the "China syndrome": Canada weathered the recession better than just about every other developed economy, thanks in part to a quick recovery in emerging economies and thus in commodity prices.

"We used to say as the U.S. goes, so goes Canada. I think today it's as the U.S. and China goes, so goes Canada," says Lindsay Gordon, president of HSBC Bank Canada. "In 20 years' time, it's more likely as China goes, so goes Canada." A year ago, the London-based multinational undertook a study entitled "The World in 2050," which projected Canada would be the only major developed economy to hold its position in the world-at the No. 10 spot-at mid-century, largely because of the demand for its resources and its ties through immigration to emerging markets (which by that time will no longer be labelled as such). China, of course, will be No. 1.

But the downside to the Canadian economy's growing correlation to China is becoming apparent too. While America's S&P 500 stock index is at the same level it was a year ago, the Toronto Stock Exchange Composite has been more closely tracking Chinese indexes. As of mid-May, the TSX was down 14% over the previous 12 months, remarkably similar to the 15% decline in the Shanghai Composite and 14% on Hong Kong's Hang Seng. Money invested in Canadian equities is considered risk capital by the global investment community, in other words, just like money invested in emerging markets.

And while Macdonald did not look into it, other studies have pointed to another major influence China has had lately on many countries, including Canada: how its high savings rate and mounting foreign currency reserves, much of it invested in benchmark U.S. government debt, have depressed interest rates around the world. That has encouraged what many are calling a housing bubble and unsustainable consumer debt loads in Canada, among other things. Moreover Chinese individuals and companies are investing in Canada at a level never seen before. Realtors widely attribute much of the surge in high-end Vancouver and Toronto home prices to Chinese buyers, and Chinese firms have invested $16 billion into Canada's oilpatch over the past two years. Chinese companies are increasingly venturing into other sectors too, such as manufacturing.

StatsCan's Macdonald is only now starting work on a follow-up paper to "China Syndrome," but based on his other research on economic trends in Canada going back to the 1870s, he says the theme he noticed in the 2003-07 period is nothing new. "If you look back at the history of this country, a lot of what shows up is a terms-of-trade gain. When [terms of trade] goes up, it means basically we can turn a barrel of oil into 60 shirts instead of three," he says. "The rate at which we can trade off what we're selling for what we're buying is getting better for us. That's been going on in Canada for a very long time."

Indeed, the biggest risk for Canada now is that the good times engendered by the "China syndrome" may be interrupted. As worries of a hard landing for China's economy began to grow a year ago, TD Economics crunched the numbers to predict just how such a slowdown would affect Canada. It wasn't pretty. If China's GDP growth slowed to 5% in 2012 from its 9.5% clip in 2011, economists Craig Alexander and Pascal Gauthier wrote, oil would fall to US$65 a barrel, non-energy commodity receipts would plunge 31.5%, Canada's current account deficit would double, and the loonie would fall to 83¢US.

"Given Canada's modest exports to China, the direct impact [of a Chinese slowdown] on trade would be limited. However, there would be enormous indirect effects.…A swift decline in commodity prices would dramatically impact Canada's terms of trade and aggregate income," the TD economists wrote. The Canadian economy as a whole would see 100 billion fewer dollars coming in, and resource-based provinces like Alberta and Saskatchewan would see a rapid pullback in investment and a spike in unemployment. And remember-that's not assuming an actual recession in China, just a deceleration to 5% growth. Were China's troubles to spark a new global financial crisis, the effects would be still worse.

The likeliest trigger to such a hard landing, the TD report speculated, would be "an overshooting in the tightening of monetary policy and lending, followed by a collapse in real estate market valuations, private investment and large losses for the domestic financial system." But the threats to China's 30-year growth marathon are many, both cyclical and structural.

Beijing reacted aggressively to the 2008-09 financial crisis by lowering interest rates and pouring money into infrastructure projects. That fuelled what many view as a real estate bubble. Tightening of monetary policy meant to cool the housing market over the past year, combined with a wind-down in public works, has served to slow GDP growth into the single digits. There's fear the policy may prove too effective. It's not clear whether the Chinese economy is bottoming out at 8% growth, or whether it will slow further.

Economic data suggest the latter. "Just about everything in China's economy seems to have gone backward in April," said a report from research firm Capital Economics. "Growth of retail spending, investment, industrial output and imports declined. Lending slowed. On the positive side, inflation fell too."

Of particular concern is the housing market. It has been on an upward price track for years, in part because the Chinese-compelled by the lack of a social safety net to save rigorously for things like higher education and in case of illness-have few other investing vehicles with which to protect their savings from the ravages of inflation. Reliable housing market statistics are hard to come by, but a number of private surveys of home prices in various cities now suggest at least a halt to the 20% annual increases, and in some cases precipitous drops. In countries from Ireland to the United States, housing bubbles spun out of control and side-swiped both the banking sector and consumer spending.

Then there is China's demographic risk. The country's one-child policy is now working its way through the age profile of the populace such that the number of hands entering the workforce is beginning to diminish, eroding Chinese exporters' labour cost advantage and, as in developed countries, raising the number of seniors unfit to work and requiring support. China's working population is projected to decline by more than 10% by 2050, while the number of retirees will triple, to more than 300 million. As many a commentator has said, "China will grow old before it grows rich." For now, rural migrants still flood the cities looking for work, but that labour pool will dry up in time. When that happens, the demographic pinch is likely to force China's economy to switch from low-cost exporter to advanced welfare state faster than any large nation has ever done before.

Another problem unique to China revolves around the lack of transparency in the corporate and financial sector. China's is a hybrid economy, where state-owned enterprises have significant advantages over the private sector. Their costs for capital, labour, land, energy and other resources are subsidized such that they generate huge retained earnings, much of which is being reinvested in foreign real assets like Canada's oilpatch, says U of T's Dobson. That foreign direct investment "could turn into a tidal wave" Canada is ill-prepared to deal with, she says. But more troubling is the opposite prospect: what happens when they have to pay higher dividends at home to the government ministries that control them, which are themselves jockeying for power? Or, for that matter, if their preferential treatment in the domestic market were taken away? "People I've talked to who have looked at the books-to the extent you can-of the state-owned enterprises and estimated what would be their profit margin if they had to pay market rates for their inputs is that a lot of them would go bankrupt or they would be far less profitable," Dobson says.

So far, opaque accounting and negligible government disclosure have hidden the costs of bad investments in municipal infrastructure, high-speed trains, shopping malls and even whole cities built from scratch for which there is no apparent demand. But the cost to the Chinese economy is there all the same and will one day become evident. When that day of reckoning comes, the huge Chinese investments in countries like Canada could suddenly be repatriated and the economies of both countries will falter.

The overarching risk in China remains political, however. The ruling Communist Party had planned a transition to a new generation of leaders this November, when seven of the nine members of the Politburo standing committee will be replaced, including President Hu Jintao and Premier Wen Jiabao. The party is now reportedly considering pushing its Congress back by two months to settle divisions enflamed by the Bo Xilai purge.

Such transitions are supposed to happen every 10 years. But this tradition only goes back to the early 1980s, with the succession of China's great economic reformer, Deng Xiaoping, and it went smoothly just once, in 2002. Moreover, the political succession is not encoded in any constitution, nor would it matter, given there is no independent rule of law in China. What matters, in politics as well as business, is guanxi (connections). It's who you know and how much of their influence they'll exert on your behalf.

But guanxi is not inviolate. In fact, it can become a liability if you're linked to the losing side in a power struggle. This is what the Bo Xilai drama lays bare. Bo was a "princeling"-the privileged son of one of the "eight immortals" of the 1949 revolution-and thus thought untouchable. He led a neo-Maoist faction in the party that favours old-style patriotism and central control of the economy. If the rumours are even partially true, he and his family abused their positions, but this puts his victorious pro-reform opponents in a difficult position. If someone like Bo is no longer above the law, neither are they.

"Seldom does a single crisis embody such a wide range of issues that go to the heart of the character of a regime," University of B.C. law professor Pittman Potter commented this month on the website of the Asia Pacific Foundation of Canada, of which he is a senior fellow. "Final resolution of the crisis will shed significant light on whether the Party is prepared to submit itself and its members to the rule of law." Which is to say it could nudge China toward a kind of governance we in the West are more comfortable with, but that's just one scenario.

In the meantime, the lesson for Canadian companies doing business in China is that while guanxi is essential, it is not durable like contract law in the West. You therefore have to do double the due diligence with prospective joint venture partners that you would, for instance, in the U.S. In their dealings in Canada, as with international transactions generally, Chinese companies have been scrupulously observant of prevailing laws and practices, but this is not their way at home.

Canada's political leaders are likewise advised to do their homework on China. But ignoring the emerging-market opportunity is not an option if we mean to keep our health-care system, our pensions and our standard of living, HSBC's Gordon says. Ottawa needs a "road map" to constructively engage the Chinese in areas such as education, immigration and investment on the way to an eventual trade agreement, Dobson argued in a 2011 paper, entitled "Canada, China and Rising Asia: A Strategic Proposal." We can complain about the opacity and arbitrariness of China's governance, she points out, but our own rules with respect to foreign direct investment are no clearer. A joint understanding on investment would help Canadian companies penetrate China's booming middle-class consumer market, where American and European firms currently have the better guanxi and market share. While they applaud the Harper Conservatives' shift toward engaging China after the chilly relations of their first two years in office, experts including Dobson wonder whether the government is sufficiently prepared to tackle thorny issues ranging from intellectual property protection to government procurement.

Finally, what should individual investors take away from the Bo Xilai affair? Caution. You can invest in state-controlled firms like Sinopec, PetroChina and Bank of China, but it's difficult to tell whether these firms would thrive were their preferential treatment taken away through economic liberalization. Likewise, to prosper, the private sector in China is dependent in large degree on guanxi and arbitrary government rules. Publicly traded Sun Hung Kai Holdings took a US$5-billion hit the day founders Raymond and Thomas Kwok were arrested by Hong Kong's anti-corruption commission in March. (Through their Canadian subsidiary, Aspac Developments, the brothers are also developing a $2-billion residential project in Richmond, B.C.) Chinese companies, however large, can't offer the relative certitudes of western and other Asian blue chips.

At a rare press conference following Bo Xilai's dismissal, Prime Minister Wen Jiabao warned that without further reform China risked plunging into another "tragedy" like the Cultural Revolution of the 1960s, when an aged Chairman Mao Zedong rallied peasants, workers and students to upend the social order as a way to vanquish his opponents. Though meant to serve Wen's political interests and far-fetched in the increasingly modern, socially networked country, the remark starkly acknowledged the country's vulnerability. Should China step backward even a bit, the consequences in Canada could be severe.

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