Comment: China's take-off depends on Hong Kong

Fact one: China's economy is already larger than that of Japan or Germany. Fact two: on present trends China will overtake the United States as the world's largest economy in 2003.

Those two facts are courtesy of Larry Summers, chief economist of the World Bank, who sketched the potential of China's economy in a paper in International Economic Insights earlier this year. In it he drew attention to what in global terms may well come to be seen as the most important economic development of the 1980s: the take-off of the mainland Chinese economy.

Yesterday's plunge in the Hong Kong market is perhaps less surprising than the surge that preceded it. That surge has to be seen in the context of Hong Kong becoming the financial capital of what will become the world's largest economy, rather in the same way another island of similar land area, Manhattan, is the financial capital of what is at present still in pole position.

The Chinese economic revolution, which started in 1979 with Deng Xiaoping's liberalisation programme, has made China the world's fastest-growing economy through the 1980s, with compound growth at just under 9 per cent. How this has been achieved is widely appreciated, but worth noting here because it is the spur behind the surge in the Hong Kong stock market for the past three or four years.

The economic triumph achieved by Chinese people abroad - in Singapore, Taiwan and, of course, Hong Kong - was in sharp contrast to the stagnation on the mainland.

This was deeply humiliating to the authorities, who were forced privately to acknowledge that they had chosen the wrong economic system for the whole post-war period. It stung them into allowing the creation of special economic zones where the capitalist system could be tried without, so to speak, contaminating the state-run system elsewhere. Unlike the Soviet Union, where political reforms preceded economic change, in China economic reforms came first.

Low wages

The industrial strategy chosen by China has been essentially the same as that of the expatriate Chinese communities: finding export niches where flexible production and low wages give a competitive advantage. (China has become a substantial exporter of telephones to the UK - if you have bought one recently, look underneath to see where it was made.) China, however, lacked the exporting infrastructure to get its goods to the world, but it had Hong Kong on its doorstep. Thus Hong Kong became the main channel through which Chinese exports reached the world. Without Hong Kong, China's economic revolution could not have taken place.

Naturally Hong Kong benefited from the role it played as entrepot trader. Aside from a hiccup in mid- 1989 at the time of the Tiananmen Square massacre, the stock market has managed a more or less sustained rise since the crash of October 1987, when to be sure it suffered a sharper fall than any other important market.

Since the spring it has been bouncing around the 6,000 level, which in the jargon of the brokers might be called a 'consolidation phase'. But even that plunge yesterday will have failed to break the upward trend line, and the immediate plunge was checked by bargain-seekers. Political relations between the UK and China may be as low as in the early 1980s, when the future of the colony was still unsettled, but the market does not signal the same gloom on the economic front. Seen in the big, the message of the market would seem to be that Hong Kong still has a role as China's financial capital, whatever the fate of its fledgling democratic institutions.

In financial terms, this is the question raised by deteriorating political relations between the UK and China: if one assumes that Hong Kong will be absorbed completely into the political system of China after 1997 and that none of its new democratic institutions will survive, can its financial infrastructure continue to prosper?

Foreign capital

Enthusiasts for Hong Kong would say yes, on the grounds of China's self-interest. The core of this argument is China's need to continue to attract foreign capital, in particular from the overseas Chinese community. Taiwan and Hong Kong are already more important sources of development capital for China than Japan. The external debt is now dollars 50bn, roughly half the size of that of Brazil. Within one generation China will probably become a substantial importer of food: with 25 per cent of the world's population it has only 7 per cent of its arable land.

Thus China needs to maintain the prosperity of Hong Kong, partly to keep open its source of foreign exchange from exports, but also to maintain a channel for capital imports from the overseas Chinese community. China does not, however, need to maintain the democracy of Hong Kong, because the places where the expatriate Chinese live are hardly bastions of Western liberal ideals. Hong Kong's own prosperity has grown despite the fact that the population has been denied political rights in the conventional sense.

That, in a nutshell, is the explanation for the continuing financial boom. Conventional wisdom holds that China needs Hong Kong if it is to do what the mainland leaders perceive is within their grasp: making China the world's largest economy by the early part of the next century. There is a further and more prosaic reason: China may need Hong Kong's expertise just to feed itself.

There is, inevitably, a counter- case: that China needs Hong Kong, but while it is potentially its greatest asset, it is also its greatest liability. It brings a profoundly destabilising force into southern China, which is already causing great tensions between Hong Kong's economic hinterland and the rest of China. Under the least favourable scenario, Hong Kong would be restrained by regulation, and would stagnate in much the same way that the great commercial centre of Shanghai has stagnated for two generations.

But if that happens, China's economic take-off will not continue: it can only continue if Hong Kong prospers. There is an obvious irony here. It is not easy to see the West feeling comfortable about a China that in economic terms outstrips the US. But if Hong Kong is to continue to have the sort of role that Britain would like to see it have, that is what will happen.