China’s Place in the Global Economy

Last week’s announcement that China’s GDP grew at an annualized rate of 7.4% in the first quarter of this year has stirred speculation about that country’s economy. Some are skeptical of the data, and point to other indicators that suggest slower growth.  Although a deceleration in growth is consistent with the plans of Chinese officialspolicymakers may respond with some form of stimulus. Their decisions will affect not just the Chinese economy, but all those economies that deal with it.

The latest World Economic Outlook of the International Monetary Fund has a chapter on external conditions and growth in emerging market countries that discusses the impact of Chinese economic activity. The authors list several channels of transmission, including China’s role in the global supply chain, importing intermediate inputs from other Asian economies for processing into final products that are exported to advanced economies. Another contact takes place through China’s demand for commodities.  The author’s econometric analysis shows that a 1% rise in Chinese growth results in a 0.1% immediate rise in emerging market countries’ GDPs. There is a further positive effect over time as the terms of trade of commodity-exporters rise. Countries in Latin America are affected as well as in Asia.

These consequences largely reflect trade flows, although China’s FDI in other countries is acknowledged. But what would happen if China’s capital account regulations were relaxed? Financial flows conceivably could be quite significant. Chinese savers would seek to diversity their asset holdings, while foreigners would want to hold Chinese securities. Chinese banks could expand their customer base, while some Chinese firms might seek external financing of their capital projects. A study by John Hooley of the Bank of England offers an analysis of the possible increase in capital flows that projects a rise in the stock of China’s external assets and liabilities from about 5% of today’s world GDP to 30% of world GDP in 2025.

While the study points out that financial liberalization by China would allow more asset diversification, it also acknowledges that world financial markets would become vulnerable to a shock in China’s financial system.  Martin Wolf warns that the down-side risk is quite large. He cites price distortions and moral hazard as possible sources of instability, as well as regulators unfamiliar with global markets and an existing domestic credit boom. Similarly,Tahsin Saadi Sedik and Tao Sun of the IMF in an examination of the consequences of capital flow liberalization claim that deregulation of the Chinese capital account would result in higher GDP per capita and lower inflation in that country, but also higher equity returns and lower bank adequacy ratios, which could endanger financial stability.

There could be another result. A sizable Chinese presence in global asset markets would lead to even more scrutiny of Chinese monetary policy. A policy initiative undertaken in response to domestic conditions would affect financial flows elsewhere, and foreign policymakers most likely would voice their unhappiness with the impact on their economies. The Peoples Bank of China, accustomed to criticism from the U.S. over its handling of its exchange rate, might find the accusation of “currency wars” coming from other emerging market countries.  The price of a successful integration of Chinese financial markets with global finance will be calls for more sensitivity to the external impacts of domestic policies.