Stephen King: Danger of a US-China trade war

All of a sudden, financial markets look rather sickly. From a Western perspective, it's not too difficult to see why. President Obama no longer appears invincible now he will be forced to confront the Republicans' new-found filibustering powers after the Massachusetts Senate race. And while the administration lashes out at the banks, some Democrats on Capitol Hill are beginning to wonder whether Ben Bernanke, the chairman of the Federal Reserve, is really up to the job.

Governments across the Western hemisphere are struggling to offer any credible solutions to widening fiscal imbalances. Might this lead to a persistent rise in bond yields beyond the control of both central banks and governments, thereby tripping up the recovery?

There is more, however, to the darkening of the financial mood. At the beginning of the year, many investors seemed to think we were living in the best of all possible worlds. While the politics of the financial crisis had not been resolved, it seemed to some that the economics of the crisis had finally been sorted out. Growth was picking up, deflationary fears were fading, asset prices had risen rapidly and, for the most part, central banks seemed intent on keeping short-term interest rates low for an extended period of time. This looked like economic nirvana: decent growth, a return of pricing power and no increase in the cost of capital.

Yet the recovery in activity in the Western world has really not been that strong. Most of the good news on global economic growth has come from the emerging world where, in recent months, the dominant story has been China. As 2008 drew to a close, many economists believed its economy was in big trouble, facing an export-led economic collapse. As it turned out, exports fell dramatically but the overall economy proved to be robust, largely as a result of hefty increases in infrastructure spending and a great big dollop of extra credit. Indeed, it wouldn't be stretching things too far to argue that China was the key driver of the global economic recovery in 2009. It's a big enough economy – about as big as Japan's and about a third the size of America's – but it is also growing incredibly quickly, typically at a pace three times faster than the US's.

A China-led global recovery marks a break with history. It brings with it some obvious costs and benefits. For the Western world, strong Chinese growth boosts exports of capital goods but, at the same time, drives up commodity prices. China, a poor country in per capita terms, has a voracious appetite for raw materials to satisfy the need for investment in infrastructure, the kind of capital spending that took place in the West many decades ago. With fuel prices still relatively high following the implosion of Western demand in recent years, it's clear that China is exerting its own gravitational pull on the global economy.

For many emerging nations, meanwhile, China's strength has provided an important counterweight to US and European weakness. Higher commodity prices have boosted the export earnings of Brazil, Chile, the Middle East and Russia, leaving their economies in a much better position compared with previous global economic downswings. The balance of payments crises of old have, as yet, been kept at bay.

China's influence needs to be taken seriously. Indeed, one of the reasons financial markets have been jittery in the first few weeks of the year is the recognition that China has to tighten monetary policy in an attempt to slow domestic demand growth. China's exports are staging a rebound not so much because of a rapid pick-up in growth elsewhere in the world but because China's exports are super-competitive. When world trade collapses, as it did last year, even China cannot cope very easily. But if world trade stabilises, as it appears to have done more recently, China's exports tend to bounce back in size. In effect, China's share of world trade is continuously rising.

For some, this reflects a seriously undervalued exchange rate. I prefer to think about China's export success from a supply-side perspective: a mixture of 21st-century capital and remarkably cheap workers prepared to offer their services for very low wages has made China highly competitive. With exports now rebounding, China is in danger of growing too quickly. Indeed, figures released earlier in the week show that the Chinese economy expanded at a 10.7 per cent rate in the final quarter of 2009, providing an average growth rate for the year as a whole of 8.7 per cent. Earlier credit expansion has, if anything, proved to be too effective, leaving growth very strong and inflation on a rising trend.

In the old days, financial markets would take fright at the thought of monetary tightening from the Federal Reserve. Alan Greenspan was treated like a colossus, in part because he seemed to set interest rates not just for the US but for the whole world. Bernanke doesn't have the same status, in part because the Fed is simply not so important as it used to be. The world is changing. Investors have to think not just about what happens in Washington but also about what takes place in Beijing. If China cools its economy, financial markets are potentially vulnerable. For the US, China's growing influence is deeply uncomfortable. The argument over Google is the latest in a long line of disagreements. Worse may still be to come. If, at the end of the year, China is still growing quickly while the US is struggling with high unemployment, it doesn't take a genius to realise that a serious trade dispute could easily emerge. The Americans claim the Chinese are deliberately undervaluing their currency, allowing Chinese companies to steal American jobs. The Chinese, for their part, claim the US is too willing to go down the protectionist route, happy to blame other nations for its domestic economic woes.

This, I fear, is an unstable situation. How it ends is anybody's guess, but China's success will be seen by Americans as a challenge to US dominance. It's not difficult to imagine a world in which a US President, desperate to shore up domestic support, adopts a populist China-bashing manifesto. We could then all too easily end up heading into a world of trade wars, heightened protectionism and, ultimately, collapsing economic activity. No wonder investors are suddenly feeling nervous.

stephen.king@hsbcib.com