Chinese could fly to EU if US crash-lands

Since the late 1990s the United States has been the world’s consumer of last resort. Its insatiable appetite for goods manufactured abroad helped to keep the European Union economy ticking over through a long period of depressed domestic demand, which is finally ending. It also helped to create the conditions which have transformed China so swiftly into the new workshop of the world, the planet’s fourth largest economy, and potentially, a continental scale superpower. But America’s rate of growth is slowing.

In the first quarter of 2007 it slumped to a turgid 1.3%. Official forecasters such as the International Monetary Fund (IMF), are optimistically predicting that the outlook will brighten as the year progresses. Nevertheless, the IMF cautions: "Growth slowdowns often are the precursors of turning points in economic activity."

In Washington, DC, economic relations with China are tense. This week (22 May) US Treasury Secretary Henry Paulson was holding his second bilateral Strategic Economic Dialogue with China amid warnings that Congress is finally turning seriously protectionist. The US bilateral trade deficit with the Asian giant soared to $233 billion in 2006, one third of the total trade deficit.

But in Europe, China-EU trade relations have been barely visible on the Brussels political agenda since last July when Trade Commissioner Peter Mandelson toughened the EU’s trade stance towards the Middle Kingdom, (ineffectually some are saying).

This is surprising given that the EU’s trade deficit with China surged 20% in 2006 and hit €128 billion, nearly $178 billion -?not far behind the US’s and still growing fast. There is also some evidence that China is "moving up the value chain" ie, exporting more hi-tech products around the world and to the EU, so exerting further pressure on EU firms which are not adjusting to the new Asian challenge.

This judgement needs a caveat. Lionel Fontagné of the Paris economic research institute CEPII, says that while China may be exporting higher tech products, often they are less sophisticated varieties. And often, says Sacha Wunsch-Vincent of the OECD, the most sophisticated hi-tech components will have been exported to China for assembly, not produced in China. Top-of-the-line microprocessors in a Chinese-produced laptop would be an example. Nevertheless, he adds, China has today surpassed the US as the world’s leading information and communication technology goods exporter, and some of its companies, telecoms group Huawei Technologies for example, are globally competitive in their field as both hardware and services providers.

EU policymakers will worry that the EU trade deficit with China is growing so rapidly even before the upheavals which could lie ahead have begun.

Over the past five years China has kept its currency pegged to the dollar - officially until 2005, latterly in the form of a managed, creeping (very slowly) revaluation against the US currency. This boosted China’s exports and its domestic industrialisation process, and, through China’s investment of much of the proceeds in US bonds, helped the US to finance excessive consumption at low interest rates.

This Faustian pact, dubbed ‘Bretton Woods II’ by two Deutsche Bank economists, may be coming to an end. Nouriel Roubini of New York University says that a US hard economic landing "would imply a sharp reduction in Chinese growth" because US consumption and so demand for China’s (and Asia’s) exports, would fall. With a full-blown US recession China’s growth could slump from 11% to 5%, he says. Worse, the financial surpluses which have helped to finance America’s huge deficit could decline, making it harder for America to attract the foreign savings it needs to balance its books.

The dollar would certainly fall further too. Financial markets, which have been enjoying highly profitable "bubble" conditions, could be thrown into turmoil, Roubini warns.

The ‘known unknown’ is how China might respond to a US recession. Would it, for example, as some say is already happening, seek to redirect more exports to Europe in order to keep domestic growth going? Would it continue to intervene in currency markets to keep its currency cheap in relation to the euro to boost already rising exports to the EU? Or are the domestic distortions, inefficient investment decisions and booming property and share prices, associated with its currency manipulation, finally going to force China to let market forces drive the yuan higher?

The EU has pressing reasons for trying to improve the co-ordination of its trade and currency policies.

Since the late 1990s the United States has been the world’s consumer of last resort. Its insatiable appetite for goods manufactured abroad helped to keep the European Union economy ticking over through a long period of depressed domestic demand, which is finally ending. It also helped to create the conditions which have transformed China so swiftly into the new workshop of the world, the planet’s fourth largest economy, and potentially, a continental scale superpower. But America’s rate of growth is slowing.