Puff the magic dragon

Where the UK economy goes over the next year or two depends on what happens internationally. As a result of relying heavily on domestic spending by consumers and government, the UK has managed to keep growing and creating more jobs. It has resulted, however, in an economy that is now unbalanced in terms of spending groups, industries and regions. In addition, since the two most buoyant parts of the economy are now dependent on borrowing to sustain spending growth, we need to look elsewhere for the demand to keep our economy on track.

Exports are the obvious route, but the international economy has offered little comfort in recent years. The British press regularly feature articles on the fragility of the European and US economies – two areas that account for about 70% of our overseas sales. Less attention, however, is paid to one part of the world that has consistently been achieving rapid rates of GDP growth with virtually no inflation. If the numbers are to be believed, the Chinese economy has been expanding annually by 7%-8% since the early 1990s. Over the last five years alone, real growth has been 45%, compared with the EU’s 12% and the US’s 16%. In this time, consumer price inflation in China has been close to zero, while in the west it has been nearer to 2% a year.

China is one of the world’s most dynamic economies. The private sector has been the main motor of rapid economic growth, with huge inflows of foreign direct investment being attracted by a combination of cheap and abundant labour and a generous tax regime. The results have been impressive.

China is now the world’s sixth largest economy, accounting for some 3.5% of global output. It has a 5% share of world trade and recently overtook the UK as the world’s fifth largest exporter. But there is still a long way to go before their living standards match those of the west. Their GDP of $1,131bn shared between a population of about 1.3 billion people produces income per head of just $3,950, just 16% of the UK level.

China will have an increasingly bigger contribution to make to the international economy in the long term, and this is making some people uneasy. Many of the goods in British high street stores are sourced from China, and pessimists predict that low labour costs will lure more jobs from industrialised countries of the west to China.

But China is facing its own short-term problems, as well as having to make long-term adjustments if it is to become a fully fledged member of the international economic community. Current growth rates cannot be sustained, and there is pressure on the Chinese authorities to tighten credit to slow the rampant investment boom. Having moved away from centralised planning, China now has uncontrolled developments at a regional level, which are expanding the supply of almost everything – factories, steel, cars – many times faster than demand. A good old-fashioned bubble is building up, which could leave builders with lots of unwanted capacity and financial institutions with huge underperforming loans. In addition, the phasing out of state-owned enterprises has helped to keep wage inflation subdued but left the country with an unemployment rate far in excess of the official 4.1%.

A period of painful structural change is on the agenda as a result of accession to the World Trade Organization last year. The process goes deeper than cutting tariffs and subsidies, and requires institutional reforms to make the Chinese market more accessible to competition. The dilemma faced by the leadership is how to deliver the legal, regulatory and financial structures required by the private sector in an open WTO-compliant economy without jeopardising its grip on power. Agriculture and industry alike will be caught up in change, as state subsidies are removed and overmanning reduced.

The new leadership is keen to enhance China’s position on the world stage, but its current attitude toward the exchange rate shows its reluctance to participate in international policy co-ordination. For years, the Chinese renminbi has been pegged to the US dollar. Now, because growth in China and a slowdown elsewhere has led to the Chinese piling up foreign exchange reserves, there have been calls for them to revalue their currency.

Viewed from the UK, it is easy to perceive China as an economic threat, but the Chinese will suffer their own growing pains. Future progress can be disrupted, as the SARs outbreak demonstrated, and a developing China becomes a potential market as well as a supply source. It could represent an opportunity for British businesses.