China as the World Economic Power?

When I first wrote a post on this blog devoted to China in July of last year, I emphasised how opaque China was as an economy. For example, I suggested that the housing construction boom might be a bubble (which proved to be the case), but could offer no solid backing for it. As such, my thoughts on the future of China were cautious:

The Chinese economy may, or may not be, at a point where internal growth within China has the potential to take up the slack. Has it yet reached that point? It is very difficult to say. It is a finely balanced point, but the economic growth of the coastal areas is now being replicated in the interior. Can the growth in the interior maintain the momentum of the coastal cities? The Chinese government has huge reserves to draw upon should the economy falter, and may seek to use those funds to further develop the interior of the country. There is also an ongoing and dramatic process of infrastructure investment which may help carry China through the bad times.

Furthermore, China has being making ever stronger inroads into markets such as Africa, and South America. Whilst these can not replace the US and European markets, they may serve to ameliorate the effects of a downturn.

As you will note, there are many question marks here. There are many 'experts' in China trying to wade through the piles of figures trying to see what will happen with China. The trouble is that many of the statistics are either opaque or suspect. In this situation, it is just as well to rely on intuition.

In a later post I emphasised the mercanilist approach of the Chinese government, and have followed that theme through many of my subsequent posts. However, the major question mark over the future of China has remained, and my posts have tried to balance the potential for huge economic success with the risks to the Chinese economy from the world economic crisis.

As China's importance in the world economy has become ever more apparent, there has been growing interest in the state of the Chinese economy. I have recently seen some reports which consider the future of China and there are mixed views. For example the D&B Riskline report for April rates China as a 'slight risk' with the trend 'deteriorating'. with very little economic growth for this year and the next. By contrast, the Economist magazine is painting a picture of strong growth on the back of the Chinese government stimulus:

At first sight, the GDP figures published on April 16th were disappointing. China’s growth rate fell to 6.1% in the year to the first quarter, less than half its pace in mid-2007. On closer inspection, however, the economy is starting to perk up. Comparing the first quarter with the previous three months, GDP rose at an estimated annualised rate of around 6%, after nearly stalling in the fourth quarter (see chart). By March the economy was gaining more speed, with the year-on-year increase in industrial production rising to 8.3% from an average of 3.8% in the previous two months. Retail sales were 16% higher in real terms than a year ago, and fixed investment has soared by 30%, signalling that the government’s infrastructure-led stimulus is starting to work.

What we have here are two very different perspectives on the Chinese economy, which appears to be the norm for analysis of the Chinese economy. To give a perspective on the opacity of the Chinese economy, analysts often use proxy measures such as electricity output to try to understand what is really going on. Understanding the Chinese economy is no easy matter.

The problem that this presents is significant. There are two very different futures that might arise depending on the growth in the Chinese economy. One scenario is of a collapse into disorder, and the other is to increasing dominance in the world economy.

As I have mentioned in previous posts, there is a belief that China needs to maintain a growth rate of 6% in order to maintain social stability. This is needed to soak up the ever expanding labour force, and failure to do so is supposed to create significant risks. In particular, the legitimacy of the Communist government rests on the pillars of economic growth and nationalism, so that any major drop back in growth might see a significant rise in discontent. An earlier report in the Economist highlighted the problems that students are having in obtaining employment after graduation, and pointed out the risks in such a situation:

Campus stability has long been a worry to China’s government. Students took a leading role in several outbreaks of pro-democracy unrest in the 1980s, including the Tiananmen Square protests of 1989. Student demands for political change have been rare since then, thanks largely to an improvement in career prospects brought about by the economic take-off and the freeing of state controls. (In the 1980s, graduates had to accept the jobs they were assigned by government.)

On the one hand, therefore, we have a scenario in which, if the economy slows significantly, there is a major risk to the stability of China overall. On the other hand there is the possibility that China will continue to grow, and the consequences of such ongoing growth might lead to a very different outcome for China.

If we assume that the growth scenario is correct, the position of China in the world economy becomes ever more important. It appears that China is currently making the opening bids to establish the RMB as a reserve currency, and I have posted on this subject several times. For example, in a recent post, I pointed out the many moves that China is making to achieve this goal:

In other words, China is now actively positioning itself as (at the least) a major issuer of reserve currency, but is doing so in a way in which - if their attempt were to meet resistance or fail - they can step back and point out that it was never their intention. They can therefore proceed with an official position of support for SDR, whilst acting to develop the RMB as a reserve, whilst never risking losing face. It is a very effective way of operating.

The post details a series of actions by the Chinese government to establish the RMB as an international reserve currency, along with some consideration and speculation about the Chinese government's thinking. You may wish to read the post before continuing. In another post (again, you may wish to read it before continuing), I made an even more speculative consideration of what the Chinese government may be aiming to achieve, and how they might achieve it. In essence, I speculated on how China might take advantage of the economic crisis to become the world economic power.

Within the speculation, I suggested that China would discreetly start to dump treasuries, and would move their reserves into a broad based portfolio of assets. Whilst China has promoted the IMF SDRs as an alternative reserve currency, I proposed that this was a red herring which would allow China to undermine the $US without actually promoting the RMB as a replacement. However, the SDR approach is being taken seriously by some:

But in recent weeks, China has begun to address each of these dollar-forever arguments head-on, taking baby steps on the long road toward diversifying away from the U.S. dollar and moving instead toward the establishment of an alternative world reserve currency.

The signs began to emerge in mid-March, when Chinese Prime Minister Wen Jiabao publicly announced that he was "worried" about China's exposure to the dollar. Shortly thereafter, Zhou Xiaochuan, the governor of the Chinese central bank, released a policy paper suggesting the creation of a "super-sovereign reserve currency" to replace the dollar as a reserve currency over the long run. Specifically, he suggested the creation of a fund, managed by the International Monetary Fund, through which dollars could be exchanged for Special Drawing Rights (SDRs), an IMF-created international reserve asset whose value is fixed by a basket comprised 44 percent of U.S. dollar, 34 percent of euro, and 11 percent of each pound and yen.

However, it is now apparent that China has made significant moves towards gold, and this was one of the moves that I suggested in the post. This would help bolster the RMB as a reserve currency. We now have the following from the FT:

China revealed on Friday that it built up its gold reserves by three quarters since 2003, making it the world’s fifth largest holder of bullion.

[And]

Hou Huimin, vice general secretary of the China Gold Association, said China should build its reserves to 5,000 tonnes.

“It’s not a matter of a few hundred, or 1,000 tonnes. China should hold more because of its new international status, and because of the financial crisis,” he said. “The financial crisis means the US dollar’s value is changing fast, and it may retreat from being the international reserve currency. If that happens, whoever holds gold will be at an advantage.”

In addition to this, China is also building up stocks of other metals such as copper. In the D&B report, this is viewed as a move towards supporting government infrastructure investments. An alternative view comes from Ambrose Evans-Pritchard in the Telegraph:

China's State Reserves Bureau (SRB) has instead been buying copper and other industrial metals over recent months on a scale that appears to go beyond the usual rebuilding of stocks for commercial reasons.

[and]

The beauty of recycling China's surplus into metals instead of US bonds is that it kills so many birds with one stone: it stops the yuan rising, without provoking complaints of currency manipulation by Washington; metals are easily stored in warehouses, unlike oil; the holdings are likely to rise in value over time since the earth's crust is gradually depleting its accessible ores. Above all, such a policy safeguards China's industrial revolution, while the West may one day face a supply crisis.

Beijing may yet buy gold as well, although it has not done so yet. The gold share of reserves has fallen to 1pc, far below the historic norm in Asia. But if a metal-based currency ever emerges to end the reign of fiat paper, it is just as likely to be a "Copper Standard" as a "Gold Standard".

The moves of the Chinese government are increasingly fitting with my speculations on a move by China to rapidly achieve economic dominance. However, it is necessary to consider the other side of this coin, which is that China is also quite vulnerable to social unrest.

The key question that keeps nagging at me is which way will China go in the coming year? Will it be a slide into disorder, or a successful bid for economic dominance? Are there other middle paths, and what might they be? Are they really making a bid for economic dominance - to be the new economic power?

With such an opaque system, it is not possible to be sure of anything. However, all the indications appear to point to an ongoing strategy from the Chinese government of placing China at the centre of the world economy. Whilst all the recent moves of China might be coincidence - responses to changing circumstances - there does seem to be an emerging pattern in their actions. If it is more than coincidence, we may be witnessing one of the most dramatic peacetime shifts in power in modern history. It could well be that China is returning to its traditional position as the preeminent country in the world.

Only time will tell......