In the world economy, the inexorable rise of China has arguably been the most important trend of recent decades. China is now the number two economy in the world and it will be number one in ten or twenty years.
To an extent, its rise to become the biggest economy was inevitable. In 1979, when China’s leadership began the long, cautious transition from Maoist Communism to the form of state capitalism they oversee today, the country was no wealthier in per capita terms than many parts of Africa. Economists would say it was far behind the ‘technological frontier’ – meaning that the tools and ways of working of most of its people were far behind the most advanced technologies and practices known at the time – while Western nations and Japan were much closer to the cutting edge.
But ideas spread.
As soon as barriers were removed, it was inevitable that China began to copy and adapt the technologies and business practices of richer nations, raising per capita incomes in the process. And, with over a billion people, higher per capita incomes mean a huge economy. Morally, we should rejoice at so many people getting a better life.
Because it still has a long way to go before completely closing the technological gap with the west, we can be confident the rise of China will continue. But market commentators can become too caught up in a narrative.
They have become so used to China being the hot prospect that many find it hard to imagine the country having big setbacks. However, all countries have shocks and setbacks. There is no reason to expect China to be any different.
Indeed, rapid development creates its own problems: pollution that runs amok before environmental laws are modernised, striking inequality between those who have joined modern sectors of the economy and those who have yet to do so, macroeconomic shocks as investment in certain kinds of physical capital runs ahead of what is needed, leading to losses for investors, and so on. We could well see an ongoing upward trajectory punctuated by some big wobbles.
The Chinese financial sector could produce particularly unexpected upsets.
China is currently internationalising its currency, promoting investment outside its borders in renminbi-denominated securities and pushing foreign firms that trade with Chinese ones to do so in renminbi. This will free Chinese firms of the costs and risks of trading currencies and will add to national prestige.
But to fully internationalise its currency and capital markets, China will have to relax its controls on cross-border capital flows, which have hitherto protected it from financial shocks and let it maintain a cheap currency to boost exports.
And herein lies the risk.
Relaxing capital controls could cause an influx of hot money, leading to a cycle of boom and bust in Chinese assets. Alternatively, it could cause Chinese savers, who earn suppressed interest rates at home to withdraw from domestic banks and invest overseas – collapsing the Chinese banking system in the process.
Chinese depositors have already turned to several kinds of unregulated fixed-term deposits – now permitted as state control is relaxed – that are offered by banks or other businesses. Some of these products pay high interest rates and are used to fund risky investments that have a much longer maturity than the deposits themselves. The Economist reports that the sector is equivalent to about 20% of bank deposits, but with far fewer controls. This could easily end up causing a banking crisis if banks’ investments cannot support the returns promised and depositors refuse to roll-over their deposits when the term expires.
For both the currency and the banks, the transition from state planning to finance with the kind of supervision normal in a regulated market economy will need careful orchestration by the government if a chaotic transitional phase is to be avoided.
What could this mean for the rest of us?
- A financial implosion in China would be a big knock for regions such as Australia and Latin America that export raw materials.
- It would hit Chinese investment in Africa and perhaps strangle the nascent progress seen there in recent years.
- It would be devastating for Western investors exposed to China.
- And US government bond yields could spike if Chinese savers were no longer buying them.
In short, a Chinese crash would almost certainly cause a world crisis at least as bad as 2007-2009. It might not happen, but it could. Risk managers of the world beware: the next shock could come from the East.
Sean Harkin is a risk manager working in Edinburgh and the author of The 21st-Century Case for a Managed Economy.