Hamish McRae: Forget trade deficits, the real worry is what China will do with its money

China is investing too much and consuming too little and exporting too much and importing too little
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There was a little item in the news yesterday to the effect that the European Commission was going to put a stiff tariff on ironing boards from China and the Ukraine. Forget about global warming, China's huge demand for energy, the fragility of Ukraine's fledgling democracy and other such issues. What matters is the strategic importance of ironing boards, for apparently those two countries have nearly half the European market and our indigenous ironing board manufacturers can't compete.

Last year it was bras, that other vital product, that China was allegedly dumping on Europe. Next year doubtless it will be underpants or pyjamas - but actually it doesn't really matter what it will be because China can make just about anything and everything much more cheaply than we can. Inflation is low in the developed world partly because of the direct impact of low-cost imports but equally because of the downward pressure the threat of such imports places on domestic producers. Low, often negative inflation in the price of goods is in marked contrast to the rise in the price of most raw materials and of most assets.

The rise in the price of raw materials is mostly a function of increased demand from China, though the long US consumer boom has also played a part. And while the reasons for the rise of asset prices are more complex, we are gradually coming to realise that China, with Japan, may play a bigger role there too.

More of that in a moment. The reason for starting with the absurdity about ironing boards is to demonstrate how policy in the West focuses on the minutiae of this gigantic shift in global power rather than its substance. The perspective from Beijing is very different.

I happened to be there last weekend. I had gone there for a conference rather than to delve into the complexities of Chinese economic policy and performance. But it is impossible to be in China without your jaw dropping at the scale of its race to prosperity. It goes on and on.

The figures suggest that unless something really dreadful happens, China will pass Germany as the world's third largest economy about the time of the Beijing Olympics. But that is just figures. To be in Beijing, a city officially of 15 million (in China second only to Shanghai at 20 million) is to feel just how irrelevant are our own concerns about such issues as the environment and migration. What we think does not matter. What the Americans think does matter a bit more because China needs the US market and the inward direct investment to create products to sell to it. But I get the impression that even the US does not have much leverage with China. China will do what China wants to do, and, as its response to pressure to revalue its currency has shown, it will not be pushed around by anyone.

The big point here is that for all the problems of managing double-digit growth, China is inherently quite a stable economy. The first graph shows how, prior to the 1978 reforms, China had experienced two economic catastrophes: the Great Leap Forward and the Cultural Revolution. But they were self-imposed catastrophes, the result of mad and destructive policies. Those twin recessions were not caused by the downturns of the global economic cycle unlike recessions in market economies. While growth has fluctuated, reaching 14 per cent a year in 1993 and dipping to 7.6 per cent in 1999, it has been remarkably even.

The latest figures show growth accelerating to 10.9 per cent in the first half of this year and the authorities are trying to curb it at the moment by tightening the supply of capital. But as the projections from CITIC Securities in Beijing show, growth is not likely to ease significantly before the Olympics in 2008. Whenever you see a boom on this scale the natural reaction is question whether it can be sustained. Eventually something will go wrong. But not yet.

One of the big problems of Chinese growth is that it has become unbalanced. They are investing too much and consuming too little and they are exporting too much and importing too little.

You can see in the next graph how investment has risen as a proportion of total GDP and how consumption has fallen to only 50 per cent of GDP, its lowest level since 1978. You see the investment everywhere, from the ring-roads round Bejing to the new airports in every major city. China does infrastructure. But you can over-invest as well as under-invest. Were growth to slow, the country would be left with white- elephant projects and the debt used to finance them - as has Japan. At some stage the balance of economic activity will shift towards consumption. It will also have to shift from over-reliance on exports to drive demand.

The trade surplus has shot up and the US and (witness the ironing board saga) Europe are becoming increasingly concerned. But though the overall surplus has risen and though the deficit with the US and Europe has risen, note too that with some parts of the world China is in deficit (third graph). I don't think we should see China's trade imbalances as simply a function of under- valuation against the dollar. It is a structural problem as much as a pricing one. So even if the renminbi is revalued - and Capital Economics thinks it will rise by as much as 10 per cent - that will not clear China's deficit with the US by any means.

That leads to a question that is even more intractable than the various imbalances. What will China do with its money?

Last week apparently Chinese official reserves went through the trillion point: $1,000 billion. The cost of holding the peg with the dollar, or rather just easing it by a small amount, is continued intervention on the exchanges. Put crudely, China lends the US the money to buy its goods, mostly buying US Treasury bills.

It was put to me that this is not a very wise policy. There it is, paying high returns on the inward investments it has attracted and earning low returns on its own cash. And that is before allowing for the foreign exchange loss from holding dollar assets. It is a mercantilist policy that increases exports but wastes much of the money thus earned.

So China will now try to use its money better. There won't be any sudden diversification but there will be a gradual shift of emphasis into higher-yielding US assets and a parallel shift towards building up assets in other currencies.

If this is right what happens to the markets? There is the currency impact and a huge amount has been written about that. It always seems to me that some limited decline in the dollar is more likely than a collapse. For that is in no one's interest. But if money is taken out of Treasury bills and put into, perhaps, equities, that will inflate share prices.

In other words it may be that asset diversification by China (and maybe also Japan) will be the thing that continues to drive up asset prices this cycle to what will eventually be unsustainable levels. I suppose you could say it will be the Sino-US equivalent to Russians driving up house prices in London. They have the money; it has to go somewhere; and there is a limited supply of assets. If we knew where China would place its money we would know what to buy first. If this cycle ends with an asset-price bubble, then Asian investment will be a material player in the process.