Why the world should worry about China

With mayhem persisting throughout Asian financial markets, China is increasingly becoming the focus of investors' attention. In one sense, the reason is obvious - sheer size. You just cannot ignore an economy with 1.2 billion people sprinkled around a land mass of 10 million square kilometres. More importantly, when measured at purchasing power parity (PPP), China's GDP has a weight of around 12 per cent in the global economy. With the Chinese economy growing at 9 per cent per annum, this alone contributes a full percentage point to global GDP growth each year.

However, China is still a very closed economy, so much of its GDP simply reflects internal business which has no meaningful effect on the outside world. As someone once said, who cares how many pigs are slaughtered in Sichuan province except the pigs? In fact, when measured at actual exchange rates, China accounts for only 3 per cent of the world economy, which is about half the size of France.

The difference between actual and PPP exchange rates is explained by the fact that prices in the sheltered service sectors of the Chinese economy are very low relative to world standards. For example, a haircut in provincial China may be only 1 per cent of the cost of a haircut in Paris when translated into dollars at today's exchange rates, but it may be worth just as much to the recipient in real (or PPP) terms. Thus GDP in China measured at PPP exchange rates greatly increases the valuation of haircuts and other items in the domestic sector, and this makes the economy look much bigger relative to the rest of the world.

China actually accounts for only 4 per cent of world trade, and for much, much less of the "investible universe" of financial instruments. This suggests that the importance of China to investors is probably better reflected in its 3 per cent share of nominal world GDP, rather than its 12 per cent weight in world GDP when measured at PPP exchange rates. Why then are we so worried about what is going on in an economy only half as big as France?

The answer is that in several respects China is pivotal to other developments in the world. First, China accounts for 20 per cent of world grain consumption, 10 per cent of metal use, and 5 per cent of world energy use. A recession in China would therefore have big implications for global commodity prices and bond markets.

Second, the behaviour of the Chinese economy is crucial for Hong Kong, and therefore for the Hong Kong dollar's peg against the US dollar. Hong Kong is China's largest trading partner, taking around one quarter of its exports this year. If China slumped into a recession, leading to a devaluation of the renminbi (RMB), these links with Hong Kong would almost certainly be enough to put intolerable pressure on the peg.

Third, if the HK peg were to break, there would be severe contagion effects in other emerging markets. For once, the knock-on effects to the rest of Asia may not be the most critical factors, since direct trade between China and other developing Asian economies is fairly minimal. But serious contagion effects may come in the area of trade competition with Japan (which takes 17 per cent of Chinese exports).

In addition, there would be severe contagion effects on other emerging economies - notably Argentina, which has a currency board system that would suffer a huge speculative attack if the similar system in Hong Kong failed. This would in turn no doubt kill off the brave attempts of the Cardoso government to defend the Brazilian real. There would therefore be serious negative effects on the US economy, both via these Latin American impacts, and via additional exports from China into the US, which is its largest customer outside Asia.

In view of the importance of all these contagion effects, it is scarcely surprising that the US authorities are so worried about the possibility of a Chinese recession, along with a consequent devaluation of the currency. Fortunately, this is not the most likely out-turn for several reasons.

First, unlike the situation in the rest of Asia prior to the currency crisis, equilibrium exchange rate models suggest that the RMB may actually be slightly undervalued. It is true that the RMB has been dragged up alongside the rising dollar against the smaller Asian currencies, and that it has now lost all of the competitive edge it gained following the 1994 devaluation. (On Goldman Sachs' calculations, the real effective exchange rate is back to where is was in 1993 - see graph.)

However, exports are still growing at annual rates of over 20 per cent, and foreign exchange reserves have continued to increase, suggesting that the problem remains one of excess capital inflows, rather than the reverse. There has been a cumulative trade surplus of $35bn so far this year, with a further $24bn coming from inflows of foreign direct investment.

On the surface, at least, this situation looks totally different from that which afflicted the rest of Asia prior to this year's currency crisis. In addition, the position of the Chinese economic cycle seems different from the rest of Asia. Essentially, the economy has been slowing for about four years under a tight domestic policy squeeze, and inflation has dropped to zero. There is consequently scope for policy to be eased.

Interest rates have already been cut by 3-3.5 per cent in the past few weeks, and the public finances appear to be in reasonable shape following three years of fiscal tightening. An increase in public investment can now be afforded, and looks likely over the next 12 months. Assuming demand policy is eased in this way, overall GDP growth can probably be maintained at about 9 per cent next year, despite a worsening in net trade.

What about the health of the financial system? A great deal of gloom has been expressed on this subject by western investors. However, it should not be forgotten that the problem in China's publicly owned banks is mainly one of bad loans to state-owned enterprises. Since the government will pick up the responsibility for these losses, the weakness in the Chinese financial system is akin to that in the former Soviet Union - ie it is a problem of allocation of losses within the public sector. This could still prove serious, but it should not undermine the economy in the same way as has occurred elsewhere in Asia. China's low ratio of foreign debt to GDP, at only around 14 per cent, should also offer protection from the worst risks of currency contagion.

Despite all this, it must be admitted that the anecdotal evidence from industrial companies doing business in China is much bleaker than the official data are suggesting, and international government officials seem increasingly worried about the situation. In view of the opaque nature of the Chinese economic statistics, the view of many private sector economists - based on these rosy official statistics - may turn out to be too optimistic. If so, the emerging market debacle would suddenly look much more serious for the rest of us.