HOW CHINA RUNS THE WORLD ECONOMY

The Economist, UK, July 28, 2005


Global wages, profits, prices and interest rates are increasingly being influenced by events in China

“IF YOU want one year of prosperity, grow grain. If you want ten years of prosperity, grow trees. If you want 100 years of prosperity, grow people.” This old Chinese proverb crudely sums up how the entry of China's massive labour force into the global economy may prove to be the most profound change for 50, and perhaps even for 100, years.

Of couse this one is more interesting


China, along with the other emerging giants, India, Brazil and the former Soviet Union, has effectively doubled the global labour force, hugely boosting the world's potential output and hence its future prosperity. China's growth rate is not exceptional compared with previous or current emerging economies in Asia, but China is having a more dramatic effect on the world economy because of two factors: not only does it have a huge, cheap workforce, but its economy is also unusually open to trade. As a result, China's development is not just a powerful driver of global growth; its impact on other economies is also far more pervasive.

Beijing's new influence was clear from the shockwaves in global currency, bond and commodity markets last week after it announced that the yuan will no longer be pegged to the dollar. Until a couple of years ago nobody cared much that the Chinese yuan was pegged to the dollar. Recently, though, this link has become one of the hottest issues in international politics, widely blamed in America for its huge trade deficit.

Last week's 2.1% revaluation of the yuan is trivial and unlikely to dent America's trade deficit. More important is the breaking of the yuan's formal link to the dollar and the shift to a so-called “managed float” against a basket of currencies. In theory, this allows considerable scope for a further rise in the yuan against the dollar, though it is unclear by how much the Chinese authorities will allow the yuan to climb.

Even if last week's adjustment was timid, it could mark an important turning point. It is certainly a step in the right direction for China itself, as greater currency flexibility will give it more room to use monetary policy to steer the economy. More interesting are the implications for the world economy. This might be the beginning of the end of what has been dubbed a revived Bretton Woods system of fixed exchange rates between China (and other Asian economies) and America.

The dragon's breath

Under this arrangement, China has provided cheap finance to America's consumers and its government by buying Treasury bonds. If the switch to a currency basket causes China to reduce its new purchases of dollar assets, then American bond yields could rise. America's China bashers, who demand a further revaluation of 25% or more, should therefore be careful. Such a large-scale revaluation would surely push bond yields higher and badly hurt America's economy. Indeed, if the yuan's adjustment has any real impact on America's trade deficit, it will not be through the revaluation itself, but because higher bond yields squeeze domestic demand.

America's trade deficit is due mainly to excessive spending and inadequate saving, not to unfair Chinese competition. If China has contributed to America's deficit it is not through its undervalued exchange rate, but by holding down bond yields and so fuelling excessive household borrowing and spending. From this point of view, global monetary policy is now made in Beijing, not Washington.

Puzzle key

The popular focus on the yuan, America's trade deficit and jobs as China's main impact on the rest of the world misses the point. China's growing influence stretches much deeper than its exports of cheap goods: it is revolutionising the relative prices of labour, capital, goods and assets in a way that has never happened so quickly before. A recognition of China's profound and widespread impact on the world economy explains various current economic puzzles.

Take, for instance, the oil price. Since the beginning of last year, oil prices have doubled, yet in contrast to previous oil shocks, inflation rates remain low and global growth robust. The answer to this riddle is China. To the extent that oil prices are driven up by strong Chinese demand rather than, as in the past, an interruption of supply, they are less likely to hurt global growth. And the impact of higher oil prices on inflation has been offset by falling prices of all sorts of goods from cameras and computers to microwaves and bicycles—thanks to China. In addition, competition from China and the threat that firms in developed countries might shift offshore also helps to keep a lid on wages and hence inflation.

Another oddity is that, while the prices of most goods are falling, house prices are soaring in many countries. Again, enter the dragon. Cheaper goods from China have made it easier for central banks to achieve their inflation goals without needing to push real interest rates sharply higher. This has encouraged a borrowing binge. The resulting excess liquidity has flowed into the prices of assets, such as homes, rather than into traditional inflation. And, last but not least, there is the conundrum which has puzzled Alan Greenspan, head of America's central bank: why are American bond yields so low despite robust growth and hefty government borrowing? Part of the answer lies, once again, with China, which has bought large quantities of Treasury bonds to hold down its currency.

Over the coming years, developed countries' inflation and interest rates, wages, profits, oil and even house prices could increasingly be “made in China”. How should the world's policymakers respond to China's growing economic clout? Trying to halt China's growth through protectionist measures, as many American congressmen would like to do, would be a disaster, for it would close off a powerful source of future global prosperity.

A better way to deal with China's growing power would be to give the country a bigger stake in global economic stability. China should be a full member of international economic policy forums, such as the G7 and the OECD. Western policymakers would be wise to remember another Chinese proverb: “What you cannot avoid, welcome.”

Background: China's economy

China introduced market reforms in the early 1980s but began emerging as a driving economic force only after joining the World Trade Organisation in 2001. China now runs a trade surplus with the United States (prompting China-bashing in the latter's Senate) and has become the world's third-largest car market. Over a dozen Chinese companies are on the Fortune 500 list; some, such as Lenovo and the state-controlled China National Offshore Oil Corporation, have begun looking for foreign acquisitions.

But growth is putting pressure on China's infrastructure, especially in the booming Pearl River Delta—while other regions see high levels of unemployment. At the same time, a lack of skills has led to labour shortages. Pollution is rife, health care strains rural resources, and the stockmarkets sag. Wen Jiabao, the prime minister, hopes to address workers' concerns by cutting farmers' taxes and giving them better medical care and education. (Some 800m Chinese, or 60% of the population, live in the countryside, averaging less than $1 a day in income.)

Still, the economy's recent growth has been seemingly unstoppable, even in the face of government countermeasures. The government raised interest rates in October 2004, the first increase since 1995, and unpegged the yuan from the dollar in July 2005, after second-quarter growth was reported at 9.5%.


Copyright © 2005 The Economist Newspaper and The Economist Group