Hamish McRae: China holds the key to gyrating markets

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The Independent Online

The markets have been gyrating up and down again. What are they trying to tell us, and should we worry?

Anyone who has gone through a couple of global economic cycles will know what it feels like to head into the dips as well as the upswings. Most of us at least will be aware of the last dip, characterised by the dot.com bust of the early 2000s, and probably the one before, which led to falling property prices in the early 1990s and brought a new and disagreeable concept into everyday language, negative equity.

So we know the animal exists: there is such a thing as the economic cycle. The trouble is that each cycle is slightly different and affects countries in different ways. In the early 1990s, the UK did rather worse than most large economies, with housing, in particular, suffering badly and unemployment soaring. In more recent cycles, we did relatively well, for though share prices had their worst bear market since the mid-1970s, the economy continued to grow throughout the downswing, and as for property prices, well, we have had the mother of all house booms.

Not only are the cycles different, what happens in one cycle affects the subsequent one. For example, the kicking out of sterling from the European exchange rate mechanism in 1992, and the subsequent fall in interest rates, was one of the features that led to the longest boom the country has ever known. The very low interest rates worldwide after the dot.com bust fuelled the present housing boom. That supported growth at the time, but probably (we don't yet know for sure) will have led to a long plateau in house prices worldwide. Prices are already falling in some markets and this has become a serious drag on the world economy.

The financial markets have all this information but they struggle to interpret it wisely. They were blindsided by the dot.com boom, failing early on to grasp how important the new technologies were, and then overcompensating by inflating their significance. Those famous words "it is different this time" are always half wrong and half right.

The new factor in this cycle, and what makes it so difficult to calibrate, is the growth of the Chinese economy. Something extraordinary is happening this year, something that has never happened before. While the US remains the world's largest economy, this year it is adding less new growth to the world than China. A lot of us thought this was happening but last week it was confirmed by the International Monetary Fund.

You can do the sums yourself. The Chinese economy is only about a quarter the size of the US but it is growing more than four times as fast. It is also, by the way, adding more new demand than the entire euro area put together.

You can see the practical effect of this demand in everyday life, most obviously at the petrol pumps. It is impossible to do a precise calculation, but I would guess that were China growing at a more normal rate, say 4 to 5 per cent, rather than its present 12 per cent, the oil price would be $60 instead of $90, and we would be paying less than 90p per litre for our fuel. But that is just a tiny example: all world commodity prices, including basic foods, would be much lower. China is a hungry growing teenager, gobbling up resources from every store in the world.

China is also affecting financial markets, though in ways that are even harder to assess. Its exports are generating a huge trade surplus and this surplus is being invested in assets around the world. Until recently, most went into US government securities. But now it, and the other surplus countries in Asia and the Middle East, are diversifying into other currencies and other assets. That must make long-term sense. But it creates new uncertainties.

Were it not for this hungry teenager, I think both the world economy and its financial markets would be even more scared than they are right now. You know the saying that when America sneezes, Europe catches a cold. Well, when the US economy turned down, it hit Europe even harder. At the moment, it is not just the US economy that is slowing; in addition there has been all the disruption from the sub-prime mortgages, disruption that, of course, has destroyed the business of Northern Rock and is continuing to weaken banks around the world.

We are not through this yet by any means. Even when the money markets settle, the concern will remain elsewhere: company profitability, the ability of heavily indebted consumers to maintain their lifestyles, maybe also the drag from lower house prices. These are the concerns that have swept through the markets in recent days.

But – and this is a huge but – while China carries on growing at the present rate, the world economy will keep growing. And if that happens, international companies selling to world markets will carry on being profitable. Meanwhile, China, plus the Middle East and Russia, will have to invest their savings somewhere. The party will continue, even if America and maybe much of Europe has to sit out the next few dances. China is what makes it different this time.

So I suppose you could almost say that China is the equivalent for this cycle of the dot.com boom during the last one. Of course, the parallel is not exact: one is an economy, the other a set of technologies. But both have the effect of prolonging the growth phase of the world economy.

The markets half understand all this but because it is all so new they find it hard to cope. So they whizz down, whizz back up, wonder whether they have made a mistake, wonder what they are missing – generally work themselves into a tizz.

So what should we make of all this? There are, I think, some things to hang on to. I can think of five. One is that share prices in most developed markets are not ridiculously high by historic standards. They were in 2000, but they are not now.

A second thing is that this China growth is real. It is scary to see. I travelled to half a dozen Chinese cities last month, and on the outskirts of each, vast new housing developments were springing up. You could see how China was using half the world's production of cement. That growth will slow eventually, but not just yet.

A third thing is that the euphoria of a few months ago has dissipated and that, paradoxically, is a source of strength. Bankers have become very worried. That is good. When they are not worried they do stupid things; now they will be sensible. Fourth, technology helps. Companies have invested an enormous amount in new technologies and continue to do so; that will help them deliver better value products and services. And finally, at last parts of Africa, helped by raw material prices, have started to benefit from growth in the rest of the world economy. That is good, too.