China to the rescue

It was a potent symbol of a new world order on August 21 when China raised interest rates for the fourth time this year in a desperate attempt to cool an overheated local economy. The move comes at a time when central bankers in the West are wondering whether they should be cutting the cost of borrowing to stave off a potential economic downturn caused by the credit crisis.

The People’s Bank of China increased the lending rate by 18 basis points (1,8 percentage points) to 7,2%, arguing there was a need to “reasonably control credit growth and to stabilise inflationary expectations”. But the move also was clearly designed to stall the continuing stampede into the red-hot Shanghai stock market.

The Chinese and some other Asian exchanges have been immune to the storms that have sent equity prices in New York and London into a downward spiral, and the Far East economic boom has saved many Western stocks from falling much faster and further than they would have done without it.

Even so, some financial analysts are beginning now to question how long the world’s most populous nation can continue to bail out Europe and the United States before it too gets dragged into the mire as it raises interest rates further or finds demand for its goods slowing down in the US.

Previous stock market crashes have often started in Asia or seen the region pull down global asset prices.
But the current strength of China and other developing economies has set a different tone.

Andrew Milligan, head of global strategy at Standard Life Investments, points out that in the last sell-off in 1998 on the back of Russian bond defaults and the collapse of the LTCM hedge fund in the US, the world economy was performing quite badly.

“Japan and Asia were in a recession and industrial production growth across the world was rather weak. This time the US is not doing so well, but China and emerging markets have been doing well. The world economy has got this safety net, this cushion of Chinese, Russian and Middle Eastern demand, which is supporting activity for exporters in Europe and the US.”

China’s growing industrial success has been built on providing everything from cut-price fridges and tele-visions to toys for Western, particularly US, consumers. A big downturn in spending at malls in Chicago will have an immediate effect on factory production in Shenzhen.

The China boom in the past few years has triggered a large increase in demand for raw materials, sending the price of metals upwards and boosting the stock prices of companies, such as miners and shipping firms.

Raw materials, such as tin and nickel, have reached record levels this year, while stocks traded on the Shanghai exchange have risen 85% during 2007 and put on 30% of that in the second quarter of the year, when markets were starting to crumble elsewhere.

By contrast, the Dow Jones Industrial Average of US stocks is up 5% so far this year and the FTSE index of the leading 100 companies in London is down almost 3% and the Nikkei in Japan by 7%.

Those figures mask the true scale of the upheaval in recent weeks since banks and other lenders began to admit their exposure to defaults in the US’s high-risk “sub-prime” mortgage market. In the past six weeks the FTSE 100 has fallen 9,4% while the wider market is down by a similar amount. In the same period the Shanghai composite index has gone up by more than a quarter, boosted by continuing optimism.

Optimism in China has helped stop further falls in London. Although the price of metals has fallen—copper has dropped from $7 910 a ton to $7 005 in the past fortnight and nickel has slipped from $31 100 per ton to $26 000 in the same period—mining experts say the damage would have been much worse without China’s huge commodity purchases.

John Meyer, at Numis Securities, says the price of commodities is coming down from ultra-high levels. “Whenever you get major uncertainty like that ... in the stock market, commodity prices and mining stocks tend to be heavily hit. There is no doubt commodities would have suffered much more if it had not been for China.”

Big mining houses such as BHP Billiton have seen their share prices plunge by 20% since early June, but Meyer points out that the stock had risen 20% before that on the back of ever-more optimistic forecasts about physical demand from countries such as China.

The outcome of global credit worries continues to be uncertain, but the fate of China is bound to have a big influence on the outlook for the world economy. Milligan says some of the confidence built into current optimistic assessments of the risk to the wider global economy is based on an assumption that, for the time being, China is not going to make any major policy mistakes.

That situation could change if it was felt in a few weeks that the Chinese economy was overheating and Chinese authorities had to raise rates again, dampening demand for commodities and other goods, he says.

“The Chinese authorities have difficult balancing acts. It’s not impossible despite all the action taken already that, come the autumn, the [Chinese] authorities feel they have to take more aggressive action to bring the economy to heel. We still have to keep a watchful eye on China.”—Â

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