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By the early hours of 8 August as the firecrackers open the Beijing Games, many will realise the world has a new axis: China has already won the economic Olympics. But China’s awesome rise is not just about cheap jeans and two-a-penny computer games – it comes with a great cost for the West. Free trade is not necessarily fair trade. Our future wealth and privileges face a serious challenge.

We forget China has been out in front before. Roughly around the turn of the first millennium, it was the world’s richest country. Measured in real-year-2000 dollars, each Chinese citizen then generated $466 a year. At the same point, western Europe could just muster an annual income of $427 a head. By the year 1500, China was richer but fast losing ground. Western Europe by then had raised its income a head to $772, while China had inched up to only $600. But over the next five centuries, China’s per capita income actually fell back to below where it stood in real terms around the birth of Christ. Thus, in 1950 China’s income a head was $448, or barely one-twentieth of America’s $9561 figure.

Nations rise and fall. By ripping off the shackles of communism, China got itself back into the fast lane ready for the dawn of the second millennium. In five decades, its per capita income rose by eight times, and over the past seven years, China has managed to grow output by 10 per cent each year, compared with the more prosaic 2.7 per cent growth in the US. If this growth differential continues, China will overtake Britain within 20 years and match the US in per capita income by 2030.

China’s cycle of success and failure is far from unique, however. In 1700, the Dutch Republic enjoyed a per capita income of $2130, or more than twice the then western European average, but by 1820 Dutch incomes had dropped back to $1838 despite the vigorous ongoing industrial revolution that was radically boosting the West’s economic power. What goes up can come down. Looking ahead, the West certainly faces relative, and possibly absolute, economic decline.

Today, China is driven forward by an Asian-style export-led economic boom. Its short-term aim has been to create millions of new jobs in modern urban industries to mop up the flooding numbers of surplus rural agricultural workers. This process is supply-driven. It requires huge amounts of credit, not least because many Chinese firms suffer miserably low returns on capital. The weaker the return on capital, the more urgent is the need to get money moving. Also, the greater the pressure to raise credit growth, the more innovative the new lending schemes and the greater the leverage applied to balance sheets to flatter otherwise thin gains.

Somehow China has to garner precious dollars and engage the Western banking systems. Crucial to its economic success is the Chinese currency’s “fix” to the US dollar. The paradoxical counterpart to China’s huge credit demands is the whopping US current account deficit. Because China is on the dollar standard, it requires US currency to back its credit expansion, and these US dollars are sucked in through the trade and capital accounts, whether as export sales or foreign direct investment.

Curiously, China is seen as supporting America with its so-called “savings surplus”. But the dependency is truly the other way around. China needs the American consumer more: Wal-Mart and Home Depot have been key components of China’s economic success. Rather than surplus savings, China has surplus industrial capacity. It is over producing and not under consuming and this policy threatens the West’s survival. Yet few can see it because they celebrate the idea that generous Chinese savers keep Western interest rates low and mortgages cheap by buying up our debt. Equally worrying, most equity market investors muddle up growth and profitability by assuming fast growth always means fat profits. It does not, as the 1980s Japan bubble and the 1990s technology bubble showed when they burst many investors’ dreams.

There is already visible danger for world financial markets: low and falling real interest rates. This puzzle contradicts the consensus outlook of pundits and investors who link real interest rates to GDP growth and immediately conclude that fast rates of world economic activity, underpinned by China, must raise real interest rates to similar 4-5 per cent levels.

What about the capital? All economic output requires input and the productivity of capital – measured by the gap between the change in GDP and the change in capital input – is what strictly governs real interest rates. Interest is a category of profits, so world interest rates are low and falling because, at the margin, world profitability is skidding.

China is the marginal producer of many manufactured products, but actually has lately suffered a negative return on capital. Thus, over the 2002-07 period every 10 per cent growth in GDP required a 10.8 per cent growth in capital stock. Not surprisingly, this has forced China to devote more than half of its entire annual GDP to spending on new capital investment. This progressive slide in the real return on global capital is likely caused by China’s dogged pursuit of mercantilism, which has resulted in overproduction and the “dumping” of surplus production in Western consumer markets.

This one-sided competition has hastened the de-industrialisation of American and European industry, forcing our firms to sit on cash and export jobs.

Because investors muddle up growth and profitability, they have ignored this skidding real return on capital. Yet this matters because all investment returns ultimately depend on profitability and only occasionally on market inefficiencies. Bond markets are largely up with events because low real interest rates already reflect the falling marginal return on capital. Equity markets are priced from the average return on existing capital. By definition, they lag, and require cost re-structuring, M&A and/or the taking on of substantial leverage to maintain returns in excess of bonds. Perhaps, this explains why many Western industrial companies have bought in their shares, pursued aggressive takeover strategies instead of investing in new plant, and continued to cut costs. Simply put, they can no longer make money through organic growth.

If future returns are compromised, where do we invest? The best combination of growth, profitability and inefficiencies lie in emerging markets, and notably in Asia. Specifically, the region’s hunger for resources should maintain the momentum of commodity prices, while low per capita income and cost levels strongly suggest some economic catch up with the West. The puzzle is that probably the greatest market anomaly or inefficiency today is the cheapness of the US dollar. And any rebound in the US currency typically means a setback for emerging stock markets and commodity prices. Our advice is to maintain a core allocation to commodities and emerging markets, alongside a tactical allocation to US dollars. As the US dollar appreciates, this cash should be used to add further to core weightings, tactically accumulating emerging market shares and commodities at what should prove to be temporarily lower prices.

Michael Howell is chief executive at CrossBorder Capital