The China Syndrome and the crisis

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This was published 14 years ago

The China Syndrome and the crisis

In the first of a three-part series on China, Satyajit Das explains its economic rise.

In 1971 Ralph Lapp, a nuclear physicist, used the term ''China syndrome'' to describe a hypothetical nuclear reactor meltdown, where the molten core melts through the crust of the Earth reaching China. The economic China Syndrome describes a process where China's strong growth, abundant savings and foreign exchange reserves assists a rapid restoration of global growth.

Glenn Stevens, the governor of the Reserve Bank of Australia, has on more than one occasion referred to the importance of China's role in insulating Australia from the worst of the present global recession. Australia's mild economic downturn, relative to the US, Britain, Germany and Japan, reflects China's position as a major trading partner and its demand for Australian commodities.

Part 2: Dragon's easy credit inflates bubble
Part 3: The model is just over the horizon

The nuclear metaphor ignores the geographical fact that the opposite side of the globe from the US is actually the Indian Ocean and that the entire idea is physically impossible. The economic metaphor conveniently discards some significant doubts about the ability of China to act as a catalyst for global recovery.

Today's economic commentary is almost unanimous in declaring China a saviour from the global financial crisis. It largely ignores how China's economic growth model contributed to the crisis.

Under Deng Xiaoping, the leader of the Communist Party from 1978, China undertook Gaige Kaifang (Reforms and Openness) - reform of domestic, social, political and economic policy. These changes were forced on the country by economic stagnation and serious social and institutional woes that could be traced to the Cultural Revolution.

The centrepiece was a suite of economic reforms that combined socialism with elements of the market economy. It entailed engagement with the global economy, reversing the country's traditional policy of economic self-reliance and a lack of interest in trade. As Robert Hart, a 19th-century British trade commissioner for China, wrote: ''[The] Chinese have the best food in the world, rice; the best drink, tea; and the best clothing, cotton, silk, fur. Possessing these staples and their innumerable native adjuncts, they do not need to buy a penny's worth elsewhere.''

In embracing markets, Deng observed that: ''It doesn't matter if a cat is black or white, so long as it catches mice.'' Deng also embraced a change in philosophy: ''Poverty is not socialism. To be rich is glorious.''

China's economic reforms coincided with the ''Great Moderation'' - a period of strong growth in the global economy based on low interest rates, low oil prices and the deregulation of key industries such as banking.

China's growth model, inspired by the postwar recovery of Japan, used trade to accelerate the growth and modernisation of its economy. The economic engine was export-driven growth. Special Economic Zones, for example in Shenzhen, located strategically close to Hong Kong, were established to encourage investment and industry.

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The model took advantage of China's large, cheap labour force. The strategy benefited from rising costs in neighbouring Asian countries such as Japan, South Korea, Taiwan, Hong Kong and Singapore. China was able to attract significant foreign investment, technology and management and trading skills from countries keen to outsource manufacturing to lower-cost locations to improve declining competitiveness.

China converted itself, at least in part, into the world's factory of choice. It imported resources and parts that were then assembled or processed and then shipped out again. The Great Moderation ensured a growing market for exports.

Innate conservatism, the desire to maintain Communist Party control of the domestic economy and avoid social disruption favoured partial market liberalisation. China's need to provide employment for its underemployed population and improve its technology also favoured this strategy. China needs to grow at about 7 to 8 per cent annually to absorb workers entering the formal workforce each year.

As economic momentum increased, foreign businesses invested to take advantage of the growth and rising living standards. Opportunities encouraged Chinese nationals living, studying and working overseas to return. As Deng noted: ''When our thousands of Chinese students abroad return home, you will see how China will transform itself.''

Over time, a novel liquidity system also accelerated growth to staggering levels. Export success created large foreign reserves that now total more than $2 trillion. These reserves became the centre of a gigantic lending scheme where China would finance and thereby boost global trade flows.

Dollars received from exports and foreign investment have to be exchanged into Renminbi, or yuan. In order to maintain the competitiveness of its exporters, China invests the foreign currency overseas to mitigate upward pressure on the Renmimbi.

As reserves grew, paralleling its growing trade surplus, China invested heavily in dollars, helping to finance America's large trade and budget deficits. It is estimated that China has invested about 60 to 70 per cent of its $2 trillion reserves in dollar-denominated investments, primarily US Treasury bonds and other high-quality securities.

Chinese funds helped keep American interest rates low, encouraging increasing levels of borrowing, especially among consumers. The increased debt fuelled further consumption, and housing and sharemarket bubbles that enabled consumers to decrease savings as the paper value of investments rose sharply. The consumption fed increased imports from China, creating further outflows of dollars via the growing trade deficit. The overvalued dollar and an undervalued Renminbi exacerbated excess US demand for imported goods.

In effect, China was lending the funds used to purchase its goods.

The Asian crisis of 1997-98 encouraged China to build even larger surpluses. Reserves were seen as protection against the destabilising volatility of short-term foreign capital flows that had almost destroyed many Asian countries during the crisis.

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The substantial build-up of foreign reserves in China and the central banks of other emerging countries was a liquidity creation scheme. The arrangements boosted growth and prosperity in China, other emerging markets and the developed world. Commodity exporters, such as Australia, benefited significantly from the increased demand for commodity and the higher prices for resources.

Satyajit Das is a risk consultant and the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.

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