China's challenge: value thy neighbours

Deng Xiaoping's economic legacy is of enormous importance, not just for China but for the world. If, as seems likely, China becomes the world's largest economy in the early years of the next century, it will be the result of the market reforms introduced by Deng in 1979. If it does not, it will be because those market reforms are reversed - though whether such a reversal could in practice take place seems doubtful.

So when, from the perspective of say 2015, we come to look back on the Deng years, we will see them as the first half of the transformation of a backward developing nation into the most powerful of the newly industrialised ones.

What might the next 18 years hold for the Chinese economy? In some ways this is an easier question to answer than the parallel question about Chinese politics. In politics there is a range of possible outcomes, from some kind of democracy to a return to rule by war lords. But in economics - if the market reforms are indeed irreversible - the range is narrower. Quite a bit of the economic landscape, including the upcoming hills, can be mapped. We can see both the potential and the problems.

To see the potential have a look at the left-hand graph, which shows growth of industrial production and investment in fixed assets since 1982. For only one brief period in 1990 did year-on-year growth of production dip below zero. Typically, growth would be between 5 and 15 per cent, with a peak at 30 per cent in early 1990. This growth has been sustained by very high levels of investment, also shown on the graph. There have been very large swings but the average growth is around 30 per cent.

Unsurprisingly, this translates into very high growth for the economy as a whole. Average growth between 1990 and 1995 was 10.5 per cent, with estimates for 1996 at 9.6 per cent. Consumption has been rising at between 4 and 6 per cent, so that while people have been becoming richer very quickly, only half of the growth has been absorbed in consumption, leaving plenty for investment to underpin future growth. The recurring problem of the 1980s, high inflation, also seems to be under reasonable control, now running below 5 per cent a year.

The great motor for this growth has been exports. It is difficult to get really meaningful current account statistics just by looking at the Chinese numbers because China's foreign trade is inexorably linked to that of Hong Kong. For all practical considerations Hong Kong is part of the Chinese economy, so any surplus on the account of China has to be added to any deficit in Hong Kong. The second chart shows the trade balance for the two (and also for that other part of what economists have dubbed "Greater China", Taiwan) for the past three years.

The main point here is that the trade balance has been in solid surplus, though a somewhat smaller surplus than appears at first sight. That is fine - except that the graph does not show who the surplus is with. The general pattern has been for China to run a large surplus with the United States, and deficits with Japan and, in particular, Taiwan. In 1995 the US took 16.6 per cent of Chinese exports but supplied only 12.2 per cent of its imports; for Japan the figures were 19.1 per cent and 22.0 per cent; for Taiwan 2.1 per cent and 11.2 per cent.

You can see here a budding problem. China seems perfectly content to run a sizeable deficit with Taiwan, and up to now the US has been content to run a sizeable deficit with China. But as the Chinese economy grows and becomes a more significant counterweight to the US, there are bound to be greater political concerns about this deficit. When Hong Kong figures are added to Chinese, the imbalance will become even greater. In 1995 21.7 per cent of Hong Kong's exports went to the US, while it took only 7.7 per cent of its imports from the States.

Politically it is reasonable for the US to run up such imbalances with its two allies, Japan and Taiwan, or with Hong Kong while it remains under the UK flag. But should it really allow such a large imbalance with a country that will not be a particular ally but a potentially hostile rival for authority in East Asia?

This leads to a second question. The motor for growth in China is astonishingly strong and will continue for a while yet. But China cannot grow in the same way as did Taiwan and Hong Kong (or for that matter, Singapore), relying heavily on the US market for its exports. What works for countries of 36 million and 6.3 million does not work for one of 1.3 billion.

But China needs the motor of exports. It will need exports to pay for energy imports, for imports of oil in particular are going to grow very fast over the next 10 years. At present, China is roughly in balance on oil trading, but the growth of motor traffic alone will push the country into large imports of oil and other petroleum products. China will also need to start importing more food.

If the US gets grouchy about the trade imbalance and Europe will not take very much more in the way of imports (Europe in any case seems likely to remain a relatively slow-growth zone), who is going to buy? Answer: China will have to rely much more on exports to the rest of the East Asian region. So the key to the next 18 years, the second half of Deng's real great leap forward, as opposed to Mao's failed leap, will lie in its relationships with the rest of the region.

This will work both ways. If China comes right then it remains a motor for the region, giving it a more solid trading anchor. Coming right means growth running perhaps rather slower than through the 1980s, maybe at about 7 to 8 per cent, for the next 10 to 15 years. If it goes wrong then the whole region will suffer. Going wrong means, I suppose, a serious recession followed by growth at perhaps 4 to 5 per cent. What signs should we look for that will tell us which way the coin will flip? There are three places to look.

The first, of course, is Hong Kong. There will be some rebalancing of the southern China economic zone, as infrastructure in the Canton region is being built up in competition to Hong Kong. But no one knows whether Hong Kong merely faces some relative decline in importance - which would not matter as far as the Chinese economy as a whole is concerned - or whether it faces serious absolute decline. It really is impossible to call this one, but it matters enormously.

The second, almost equally obvious, is Taiwan. Present policy is, in effect, "growl but trade". Will the growls grow and the trade be squeezed? Or will the export performance of Taiwan, whose 21.5 million people export two-thirds as much as China's 1.3 billion, become a source of regional strength for China too?

And the third is Japan, China's only other rival for regional dominance. In theory, the two countries are perfect partners. One has the technology and needs the market; the other has the market and needs the technology.

But managing that relationship means overcoming continuing distrust. It may become harder to manage, not easier, as China's economic weight grows.

And it will grow. Even on modest assumptions, say a halving of the growth rate of the past 18 years, it is difficult not to see China outpacing the US at some stage in the second decade of the next century. You have to assume a real economic catastrophe in China, which would be more damaging for the world economy, for China not to be the largest economy.

It has become a popular image that the 21st century will be the Asian century, following the European and American ones. You do not need to buy that idea, though, to accept that the first decade of the next century will probably be China's.