TCS Daily

When the Bank of China Wakes

By Desmond Lachman - May 14, 2004 12:00 AM

Judging by recent global market jitters, Napoleon might very well have been referring to the Bank of China and the global economy when he uttered his famous warning some two hundred years ago that "when China woke the world would shudder." However, it is unlikely that even Napoleon would have anticipated the complexity of the choices now facing China's policymakers as they try to engineer a soft landing for their economy. Nor would he likely have foreseen how vital a Chinese soft landing would be for the continued health of the global economy.

The importance of China to the global economy derives not so much from the size of its economy but from the fact that China has continued to grow at a remarkable 9 percent annual rate at a time that the rest of the world half-slumbered. As a result, while China accounts for only 4 percent of world GDP, it has accounted for as much as 15 percent of the world's GDP growth and almost 20 percent of the growth in world exports and imports.

These figures understate the importance of China's role as the locomotive for its neighbors, including Australia and Japan, which have become increasingly dependent on the 40 percent growth rate in Chinese imports. They also understate the importance of China as the dynamo for the boom in international commodity prices, including aluminum, copper, petroleum, and soybeans, which have helped keep Latin America's economies afloat.

No less impressive is the importance that China is assuming in the international capital markets as its external sector has strengthened and as foreign capital has flooded into China. By April 2004, China's holdings of US Treasury bonds approached US$400 billion, while it now accounts for almost 12 percent of each new auction of US Treasury paper. Were China to withdraw from the US Treasury market for any reason, ripples would be felt globally as US interest rates would be forced sharply higher.

The immediate risk that China now poses to the global economy is that it simply cannot continue growing at its recent torrid pace without stoking domestic inflation. In particular, it is difficult to see how China might sustain the 19 percent rate of industrial output growth or the 43 percent rate of overall investment growth that it registered in the first quarter of 2004. Inflation at the consumer level is already ticking up to 5 percent, while the growth in China's monetary and credit aggregates is now exceeding 20 percent.

Recent pronouncements by Chinese policymakers clearly suggest that they have become increasingly concerned about the risk of an overheated economy. However, they recognize that they are not equipped with the normal monetary policy instruments that would increase the prospects of a soft-landing for the economy. Indeed, the Bank of China recognizes that there are clear limits to the use of interest rates to cool the economy in the context of a currency that remains pegged to the US dollar.

Any attempt by the Bank of China to raise interest rates in such a context would tend to be neutralized by further encouraging the large inflow of "hot money" from abroad. And the Bank of China is not willing to contemplate a large revaluation or the floating of the currency that would restore potency to interest rate policy for fear of losing China's present international competitive advantage. Chinese policymakers view the maintenance of an undervalued currency as vital to generate the much-needed urban employment that might solve their chronic problem of rural unemployment.

Instead, in their effort to slow the economy, the Chinese authorities are being forced to regress to the blunt instrument of administrative credit and investment controls, whereby the government dictates to the banks to whom and how much they might lend. Apart from representing a retreat from the move to a more market oriented economy, such administrative controls constitute a hit-and-miss way of slowing the economy and heighten the probability that China has a hard landing.

For China's sake one can only hope that the Chinese policymakers follow through on their pronouncements to cool China's economy soon before the imbalances in that economy get worse. From a global perspective, one can only pray that they are blessed with good luck in applying the crude tools at their disposal to reign in an overheated Chinese economy without precipitating a hard landing that would be so damaging to the world economy.

Desmond Lachman is a frequent contributor. He recently wrote for TCS about it being Time for a New Broom at the IMF.


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