In the second of a three part series, Satyajit Das explores the unstable co-dependency of the Chinese and US economies.
In 2007, unsustainable levels of debt in many economies triggered a near collapse of the global banking system that, in turn, triggered a major slowdown in growth.
The external demand shock, with sharp decreases in consumption and investment from the developed world, hit the Chinese economy. The sudden fall in exports led to a slowing in China's stellar growth rates in 2008, triggering declines in stock and property markets.
Job losses in export-intensive Guangdong province were in excess of 20 million. Workers and students entering the workforce were unable to find jobs. Fearful of social instability, Beijing moved quickly to restore rapid growth.
Government spending and loose monetary policies increasing credit are driving China's recovery, contributing about 6 per cent of growth of 8 per cent in 2009. In the June quarter, Chinese exports (35 to 40 per cent of the economy) fell by about 20 per cent, implying that the non-export part of the economy grew strongly.
In the first half of 2009, new loans totalled over $US1 trillion. This compares to loans for the full 2008 year of about $US600 billion. Current lending is running at around three times 2008 levels and at a staggering 25 per cent of gross dometic product.
The availability of credit is fuelling rampant speculation in stocks, property and commodities.
China's recovery, in turn, underpinned the recovery in commodity prices and economies dependent on natural resources. In recent parliamentary testimony, the assistant governor of the Reserve Bank, Philip Lowe, highlighted the extent to which Australia's export performance relied on Chinese demand. He noted that 23 per cent of Australia's exports went to China in the most recent quarter, up from 4 per cent 10 years ago. China takes 80 per cent of Australia's iron ore exports and 20 per cent of coal exports.
While some commodity imports were restocking inventory, low-cost finance combined with a fear for the long-term prospects of US Treasury bonds and the dollar has encouraged speculative stockpiling, artificially boosting demand.
Government spending and bank loans have resulted in sharp increases in fixed asset investments (up over 30 per cent on 2008). A major component is infrastructure spending, accounting for more than 70 per cent of the Chinese Government's stimulus package.
Infrastructure investment is adding to production capacity in a world with sluggish demand and overcapacity in many industries. In the absence of domestic demand, the production may be directed into exports, increasing the global supply glut and creating deflationary pressures.
Progress on shifting the emphasis to domestic consumption has been disappointing. Government incentives, in the form of rebates for purchases of durables such as cars and whitegoods, have increased consumption in the short run. But over the last 25 years, Chinese consumption has declined from around 50 per cent to its current levels of 37 per cent.
The expansion in lending risks creating China's own banking crisis with a rise in non-performing bank loans. The problems of bad debts from loose lending are not new. In the 1990s, a similar credit expansion led to an increase in bad debts. The big state-owned Chinese banks had to be recapitalised and restructured in a series of steps that ended as recently as 2004.
Chinese regulators are concerned that new lending is being used to finance real estate and stock speculation rather than for productive purposes. They have moved to try to reduce speculative lending but it is likely that the central bank will maintain its moderately loose monetary policy because of uncertainties in the external and domestic environment.
The centralised control structure of the Chinese economy has allowed rapid action to be taken to avert the slowdown in growth.
In July 2009, Su Ning, the vice-governor of the Chinese central bank, the People's Bank of China, observed that ''the mind and action'' of all financial institutions should ''be as one'' with the Government's goal, and financial institutions should properly handle the relationship between supporting the economy's development and preventing financial risks. Even if execution is not in question, the appropriateness of the policy measures and the sustainability of the recovery are unclear.
There are also concerns that Chinese statistics are unreliable and manipulated by officials to meet political and personal objectives. One nagging discrepancy is the difference between reported growth figures and electricity consumption. It is difficult to reconcile falls in electricity consumption with continued robust economic growth.
International commentators have become concerned about the quality of economic data. Commenting on the time taken by China's National Bureau of Statistics to compile growth data, Derek Scissors, from the Heritage Foundation in Washington, observed: ''Despite starkly limited resources and a dynamic, complex economy, the state statistical bureau again needed only 15 days to survey the economic progress of 1.3 billion people.''
China's $US2 trillion foreign currency reserves, a large proportion denominated in dollars, may have limited value. They cannot be liquidated or mobilised without massive losses because of their sheer size. Increasingly strident Chinese rhetoric reflects rising concern about the security of these dollar investments as the US issues massive amounts of debt, reducing the value of Treasury bonds and the currency.
The Chinese Premier, Wen Jiabao, has expressed concern: ''If anything goes wrong in the US financial sector, we are anxious about the safety and security of Chinese capital.''
In December 2008, Wang Qishan, a vice-premier, noted: ''We hope the US side will take the necessary measures to stabilise the economy and financial markets as well as guarantee the safety of China's assets and investments in the US.''
China's position is similar to that of a bank or investor with poor quality assets. It is trying to switch its reserves into real assets - commodities or resource producers, where foreign countries will allow.
Meanwhile, in a surreal logic, China continues to purchase more dollars and US Treasury bonds to preserve the value of existing holdings. On the other side, the US continues to seek to preserve the status of the dollar as the sole reserve currency in order to enable the Treasury to finance America's budget and trade deficit.
Almost 40 years ago, John Connally, then the US treasury secretary, accurately identified China's problem: ''It may be our currency, but it's your problem.''
China's position is like that of an unfortunate who has stepped on a type of anti-personnel mine, known as a bounding mine. The mine does not explode when you step on it. Instead, it trips when you step off it as a small charge propels the mine into the air where it explodes at waist level. China, in building and investing its massive foreign exchange reserves in dollars and US Treasury bonds, has stepped on to the mine and it cannot step off without serious damage.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives