Markets feel the chill from China

Stock markets around the world suffered another day of huge losses yesterday as fears of the global recession spreading to China prompted a renewed bout of negative sentiment.

The FTSE 100 index of leading UK companies lost more than 7 per cent and the Dow Jones Industrial Average in the US was down by almost 6 per cent by mid-afternoon. The gloom in credit crunch-hit Western economies deepened with UK unemployment figures showing a 164,000 rise in the three months to August, and US reports of the biggest monthly fall in retail sales for more than three years.

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The sell-off overshadowed Gordon Brown's attempts to convene a global summit to tackle the economic crisis. There were also renewed concerns for the financial health of local authorities in Britain who have been hit by the collapse of banks in Iceland

The sell-off was prompted in part by warnings that China's economy, which has been expanding at breakneck speed for years, would "pause for breath". Guy Elliott, the finance director of Rio Tinto, the mining giant, said: "We are confident about the future in China, but at the moment there is a deceleration of demand that won't pick up again until next year."

His comments caused panic in the commodity markets. The oil price dropped by 5 per cent to a 13-month low, and copper, aluminium and nickel all slumped. Only gold, seen as a safe haven in troubled times, stayed stable.

Economists are already cutting forecasts for China. The International Monetary Fund (IMF) last week predicted growth of 9.7 per cent this year and 9.3 per cent in 2009. The danger is that the health of China's economy is hard to measure, and Beijing's economic policy even harder to predict.

And just as its semi-command economy was central to the cheap-credit era that is now causing such a hangover in Western economies, so its response to the aftermath is the key to the world's recovery, said Diana Choyleva, a director at Lombard Street Research, a think-tank. "The combination of macroeconomic data and anecdotal evidence, such at that from Rio Tinto, gives an ambiguous message because GDP data for the first two quarters of the year do not show anything yet," she said. "But China has to have a slowdown and what is important is how Chinese policymakers respond."

Mining stocks, which have been boosted by China's rampant demand for commodities, were hit particularly hard. Concerns about weakening demand from the global powerhouse wiped 16.6 per cent off Rio Tinto's value by the end of the day – and 19.6 per cent and 22.27 per cent were knocked off the value of Xstrata and Kazakhmys respectively.

China's economic growth – which ran at 11.7 per cent last year – is a key factor in the high oil and commodity prices causing extra problems for developed economies wrestling with toxic combination of the credit crisis and slowing consumer spending. But if China follows the West into recession, the effect could be even more severe.

But it is too early to tell to what extent the West's recession will infect China, and even at about 9 per cent, the economy is still growing fast. Robin Geffen, the manager of the Neptune China Fund, says the impact of developed economies' demand is overplayed. "Not only is the rest of Asia geared towards China but it has very fast-growing domestic consumption as a percentage of GDP and a massive infrastructure spend," he said.

The Chinese government has been deliberately slowing growth through tight economic policies for the past 12 months to cool off an otherwise overheating economy. Loosening monetary policy would have real effect, as would using some of the vast reserves of cash.

"Monetary policy in particular has been quite tight recently – such as not allowing the money supply to grow anywhere near as fast as industrial output and leaning on the banks to control lending," said Ian Beattie, the manager of New Star's Asia Pacific Fund. "There is a lot of firepower in both monetary and fiscal policy."