Outlook: Why the world's economy is stuck on a fast boat to China

Where Might the next big crisis in the world economy happen? Here at the World Economic Forum annual meeting in Davos, Switzerland, there are only two answers on everyone's lips - China or the United States, or perhaps both given how joined at the hip the two economies seem to have become. Yet few think such a crisis at all likely any time soon.

To the contrary, after four grim years for business, there is a tangible air of optimism, a new spring in the step and a general belief not only that the worst is over, but that the world is back on the path to sustained growth. America's twin budget and trade deficits are generally regarded as a cause for concern, but in the back-to-business atmosphere of chief executives here, they are one best left for another day. Even the movers and shakers of the technology industry are walking around with broad grins on the faces. The nuclear winter in information technology orders seems finally to be lifting.

But amid the hustle and bustle of the conference centre's labyrinthine corridors, three words constantly echo - China, China and China. This once mired and closed economy, still presided over by a totalitarian, one-party state, has over the past year established itself as the new dynamic of the global economy, with the power utterly to transform the business and commercial landscape. Indeed it is hard to talk about any of the big issues facing the global economy right now without mentioning China.

Japan's economic recovery depends on it, the US budget deficit is partly financed by it, the currency markets are ruled by the perversity of its dollar peg, and the future of many of our companies and industries may well be determined by it. Everyone is talking about the Chinese development story, and what it might mean for the rest of us. Everyone has got their own view.

Donald Evans, the US Commerce Secretary, is bullish to the point of euphoric, as he perhaps needs to be. Through currency intervention, China is one of the largest single purchasers of US Treasury bonds, helping to finance the US budget and current account deficits, and keep American interest rates low. For the Bush administration, China is the pin-up girl of emerging markets. The relationship between the two countries has never been better, with George W Bush having already visited Beijing twice during his presidency. This might seem odd, given China's carelessness with human rights and its failure to develop even the most basic of democratic institutions. With other dictatorial regimes, the American instinct is to topple them. Instead, China gets the red carpet treatment.

It's an easily explained contradiction. Rightly or wrongly, Mr Evans believes that the determination being shown by China in its pursuit of growth and prosperity, and the skill with which it has so far managed its economic transformation, will eventually lead to its democratisation.

Once people have fed and housed themselves, they begin to seek self determination, education and political freedom. Political reform will follow inevitably from economic transformation, Mr Evans believes. But political change must be allowed to happen at China's own pace. Too much too fast might result in a calamitous road crash.

Most Conventional economic analysis would paint China as an accident waiting to happen in any case, yet despite an apparently breakneck pace of development - by some estimates industrial production is expanding at close to 15 per cent per annum - it is surprising how few people hold that view. Many of the prerequisites for a fully blown financial crisis are already in place - an overheating economy, a banking system where perhaps as much as 40 per cent of the loans are bad, underperforming or uncommercial, and an inflexible exchange rate regime that pegs the value of the renminbi to the US dollar. Yet there are some key differences too. The inflow of hot money and foreign capital, although vast, is still only 8 per cent of capital formation with the rest generated internally, according to figures cited in Davos, while household savings at 100 per cent of GDP are enough to make Western policy makers, grappling with the problem of growing consumer debt, green with envy. Despite the surge in infrastructure spending, which is sucking in vast imports of oil and capital equipment, there's still a current account surplus. Few business leaders are prepared to predict when China might abandon the dollar peg, though all agree that eventually it must.

One exception is Victor Chu, a leading Hong Kong based financier with extensive interests in China. His prediction is intriguingly precise. China will move to a more flexible regime, with the renminbi linked to a basket of currencies traded in a relatively broad band in nine months' time, he thinks. One Chinese banker said that as a first step, China might move to a trading band of 2.5 per cent against the dollar, but he confirmed that the political leadership is reluctant to accept even a partial flotation any time soon. Mr Chu is as well informed as any about China, so his advice to companies that they should invest in China now before the currency rockets upwards should be taken more seriously than most. In his view, that window of opportunity will be largely gone by the end of the year. But watch out for monkey business. Those that enter China without high calibre partners will lose their shirts, he warns, and you need friends in the right places to get your money out.

Some business leaders remain unconvinced. Carlos Ghosn, Nissan's now globally fêted chief executive, must invest in China because for the auto industry, it's potentially such a vast growth market. But he finds doing business there tough and thinks it will be at least 10 years before China's auto industry is as efficient and profitable as those of Japan and the US. Don't confuse low labour costs with high levels of productivity, he warns. The most productive car plants in the world are those that pay the most. Perhaps regrettably, this more sanguine view of the Chinese threat to industry in the developed world is not at all typical.

There'S Been some ritual bashing of the European Central Bank in Davos, now such easy sport as to be almost cruel, but so far Europe hasn't figured much in debate. Long gone are the days when European policy makers and business leaders would come to these meetings to trumpet the virtues of the European economic model, presented as a socially acceptable alternative to America's red in tooth and claw capitalism. It has failed to deliver, and with China growing like topsy, there's a real danger of that failure intensifying.

The Chinese threat to Europe is articulated at its starkest by Ulrich Schumacher, chief executive of Infineon Technologies, the German micro-chip maker. He puts it much better than I can, so I'll let him speak for himself. For Europeans, it makes depressing reading. "At Infineon, we plan to shift more than 30 per cent of annual investment, worth between $1bn and $2bn, to China over the next two years. This is not just commodity production, but our most advanced technologies. The Chinese advantage is not confined simply to low labour costs. China's innovation rate is higher, its technical abilities can be stronger, and we are able to run our plants on three shifts, 24 hours a day, seven days a week. Innovation is better and our time to market from China is superior. It is increasingly hard to justify research and development spending in Germany because I can do it better, cheaper and faster in China. I'm sorry to say it, but my bankers find it much easier to lend for investment in China than they do in Germany."

It would be hard to articulate a more alarming wake-up call. China faces huge social and political challenges as it shifts, at a pace never before attempted in history, from an agrarian to an industrial-based economy. Is the Chinese political leadership capable of managing such a breathtakingly ambitious endeavour? The fatuous answer is that only time will tell. But the final word should go to Mr Schumacher. "I would love to have the same awareness of the urgent need for structural change in my country as they have in China."