Fuss About China Is Overdone

Last week’s Chinese New Year holiday brought, literally, a rare breath of fresh air to Hong Kong. With thousands of mainland factories temporarily closed, the choking toxic smog that regularly envelops the city cleared briefly. As it did, a question struck me: what if China – or, more precisely, its domestic economy – took an extended holiday?

Granted, a serious setback to Chinese growth does not seem on the cards soon, given its recent strength. Nor, evidently, was the possibility much on the minds of the business leaders who drooled over the Chinese miracle in Davos last month. But it is not inconceivable. Several, internally generated, upsets could precipitate a sharp slowdown: a deflationary spiral caused by the country’s chronic over-investment; a property market crash; or a series of policy blunders.

Assume, too, that nothing else threw the global economy off course and – a big assumption, admittedly – that China was not destabilised by serious social unrest. Would the rest of the world be worse off? The answer is “probably”, but by less than many suppose – and much of the cost would be in unrealised potential income gains, rather than in absolute losses.

Despite its increasing contribution to global growth, China’s share of world income and output is still modest, at around 5-6 per cent in US dollar terms. And although it is the world’s third biggest trader, its share of global imports is similar, and barely one-third that of the US.

Furthermore, in a recession the fall in its imports would be uneven. Foreign producers of capital goods and of commodities of which China is a large user would be hit hardest. But it would not be a knockout punch, because about half the country’s imports go into making exports. These might even increase, as more output was diverted abroad in response to weaker demand at home.

Consumer products would be little affected because so many are made locally. China’s market is in any case only one-tenth the size of the US. Some industrial imports, such as steel, are already in rapid structural decline anyway, as domestic processing capacity expands. Others, such as car components, will soon follow.

Nonetheless, reduced exports to China, and to economies that rely heavily on its market, would lead to some income losses elsewhere. But they would be at least partly compensated for by lower energy and commodity prices, as Chinese consumption moderated. Oxford Economics, a consultancy, estimates that a 30-basis-point cut in interest rates would offset most of the impact on the US of stagnant domestic demand in China.

Of course, the inevitable rise in China’s current account surplus would risk triggering a US backlash and new protectionist threats. But that is by no means a certainty. Washington opinion is fickle and easily distracted. Strikingly, Congress has so far emitted barely a squeak after the huge growth in last year’s surplus.

Foreign direct investment in China might weaken, particularly as inflows are increasingly targeted at the domestic market. However, a growing chunk is chasing “once in a lifetime” opportunities to invest in existing financial institutions, rather than in greenfield projects, and to pioneer products and services new to China. A cyclical downturn would probably not be enough to choke off such inflows.

A sudden Chinese slowdown might be a nasty shock for over-extended speculators in commodities, if it induced steep price falls. But otherwise, the risk to international financial markets seems low. The country still tightly controls both capital outflows and inflows. Its external debt is modest, and its domestic bond and equity markets so shrunken as to be near invisible.

There would be little reason, either, for Beijing to change its foreign exchange reserves policy. Indeed, greater dependence on exports would strengthen its incentive to prop up the dollar. It is, in any case, trapped by a Catch-22 dilemma. Trying to improve returns by diversifying out of dollar assets could reduce them by prompting a fall in the US currency.

Of course, all the above is pure hypothesis. It may well never come true, and if it did, events might not unfold quite as I have suggested. But that is not the point. The world has become so mesmerised by China, oscillating between greed for its market and fear of its growing might, that the euphoria is in danger of parting company with reality. A more sober perspective is needed.

Four things must be borne in mind. First, the most distinctive feature of China’s economy at present is its velocity, rather than its mass. Second, its importance to the rest of the world, though growing fast, is mainly at the margins. Third, it is easy to confuse the reality of the “Little China” of today with heady visions of a “Big China” of tomorrow. Finally, when economies and markets behave exactly according to straight-line extrapolations of their future course, it is the exception, not the rule.