Economic View: Clouds on China's horizon: could the greatest growth story ever told have an American sting in the tail?

The signs in Shanghai point to continued prosperity, even through the smog, but the troubled relationship with the US needs to be repaired
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The Independent Online

Shanghai – the great Chinese boom continues, with growth racing ahead at 10 per cent a year, transforming the entire global economy as it sprints onwards. In Shanghai, you are perhaps more aware than anywhere else of the scale of what is happening: one-third of all China's trade is shipped through here. The visible signs of the boom are evident everywhere – from the glitz of the shopping malls with the cheerful 20-somethings and their packed carrier bags, to the grit of the construction sites, where you can glimpse the off-duty workers sleeping in on-site dormitories with 10 bunks packed to a cabin.

It is a boom that seems almost perversely unaffected by the global financial ructions of the summer. Elsewhere in the world, deals are being postponed because finance is drying up and values have fallen. Here, just this week as share prices were hitting new records, a Goldman Sachs purchase of a stake in a Chinese consumer goods giant was pulled for exactly the opposite reason: the share price had risen some six-fold since the deal was originally proposed last year, and getting regulatory approval had taken so long that the deal was no longer viable.

Soaring shares create their own problems. Until nine months ago, prices had been flat for several years. Alone among major markets, the Shanghai index had failed to join in the post-2003 recovery. Then, largely as a result of regulatory changes on institutional and foreign investment, the index took off, generating a sudden burst of wealth for the hardy souls who had for years persisted in buying shares. One way markets lead to other problems: I spent a morning at the Shanghai Stock Exchange and one of the main issues discussed was the need to educate Chinese share buyers about the risks associated with trading.

That leads to a more general issue, one of vital importance to China and the rest of us: is the Chinese economy overheating and might there be a bumpy ride ahead? The authorities are certainly aware of the danger and have taken various steps to try to hold it back. Inflation, currently running at over 5 per cent, is a widely recognised problem, as is demand for raw materials. This is a country producing half the world's cement. On average, it commissions a new coal-fired power station every four days.

We are acutely aware of the environmental costs of such growth in air pollution – even in Shanghai which, given its size of some 20 million people, is a pretty clean city.

These are vital issues for the medium term and any visitor is frequently reminded of the need to improve energy efficiency and pollution controls. Eventually, these will be tackled. But do not expect China to slow growth voluntarily to any significant extent for another decade at least.

The issue is whether growth runs a bit above 10 per cent or a bit below. Expect a figure of more than 11 per cent this year.

The threat, it seems to me, is more likely to be external – China's trade relations with the rest of the world, and in particular with the US. The sudden take-off of China's trade surplus since 2005 is widely recognised. Less appreciated is that this surplus is entirely with the US and, to a lesser extent, Europe. The country is actually in deficit with Asia.

The US will not allow this to continue, nor is it in China's self-interest that it should; there is little point piling up US assets that offer at best low returns and at worst a substantial loss of capital value, when the money could earn a far higher return at home.

But how should China fend off rising protectionist pressure from America? Allow a faster revaluation of the yuan? Well, the Chinese currency is creeping up against the dollar by around 6 per cent a year and it is not at all clear that a faster rise would help much. One new thought is the extent to which China is determined to avoid the mistakes of Japan in the 1980s, when the yen was pushed to extreme levels, in part by US political pressure.

A senior foreign exchange official pointed out last week that the revaluation of the yen was a crucial element in Japan's late- 1980s boom, and its subsequent recession, from which it has only been recovering in the past couple of years. That was why China would not participate in an agreement to revalue the yuan, but insisted on the managed float. Although the Japanese revaluation achieved its objective in heading off US protectionist measures, it also led to increased Japanese investment in the US, with the big motor manufacturers and electronics firms setting up plants there. So there were positive effects and one should not attribute the difficulties Japan had in the 1990s to a currency agreement. What went wrong was that Japan let its boom get out of control, encouraging companies to borrow and invest far too much.

This danger for China is still some way off. Besides, the US deficit is fundamentally the result of US policies, not Chinese ones. Even were the yuan to be substantially revalued, America's chronic excessive consumption and weakness of savings would continue. That will not, however, stop the rise of protectionist pressures in the US.

At some stage, the imbalances between the US and China have to be reduced, and the key issue is what role this tension will play in the downturn, whenever that comes. In the past month, we have seen the sort of breakdown in the markets that just about everyone expected at some point, but it was still surprising when it happened. An accident was waiting to happen. Much the same could be said of the China-US relationship.

I am not gloomy about China's prospects – when you see the changes in a place such as Shanghai, how could anyone be? This is the greatest sustained boom the world has ever known. Nor should people be too gloomy about the US, given its ability to reform itself. But the relationship between the two will get worse and that is troubling indeed.