China's attempted economic transition has deep implications, not just for the emerging nation, but for the rest of the world. In the short term, the challenge is to manage spillovers from what might be a sharp slowdown in China's economic activity. In the long term, it is how to cope with the integration of a financial powerhouse into the world economy. In reality, however, what happens in the short term will shape the longer term as well.
India's latest Economic Survey provides a thought-provoking taxonomy of crises. The external impact of a crisis depends, it argues, on whether it occurs in systemically important countries, it is the result of fiscal or private borrowing and whether currencies of affected countries appreciate or depreciate.
What might this analysis have to do with China? The answer is that it is a systemically important country that suffers from high and rapidly rising corporate indebtedness. This might lead to a sudden halt in investment and a rapid depreciation.
Such a sharp slowdown is not at all impossible. The combination of an ultimately unsustainable rise in corporate debt with the dependence of demand on ultra-high rates of investment creates the vulnerability. As the economy slows to growth below 7 per cent a year, investment rates of close to 45 per cent of gross domestic product no longer make economic sense. The private sector is also responsible for close to two-thirds of investment. So market forces might impose a painful adjustment.
One might envisage two government responses: a huge increase in fiscal deficits, as in the Western financial crises, and a more aggressive monetary policy. But a weaker exchange rate might also be welcome as a way to offset domestic deflationary pressures.
At the China Development Forum held in Beijing this month, People's Bank of China governor Zhou Xiaochuan indicated that it was reasonable to run down foreign currency reserves built up on a massive (and unplanned) scale. But there must be some limit to that. Controls on capital outflows could also be tightened, even though that would go against China's plans for opening up the capital account.
While the Chinese economy has been weakening, monetary and credit policy loosening and the exchange rate falling, no such crisis is to be seen as yet. The main drivers of the capital outflows also seem to be pre-payment of foreign currency loans and the unwinding of "carry trades", partly triggered by perceptions of a greater risk of a depreciation of the renminbi.
Again, while weakening, the growth of demand has certainly not collapsed. So far, so good then. But this story is not over.
The world economy is in no position to absorb another big deflationary shock. The possibility of such a shock from China over the next several years is real. But a longer-term issue also arises: how to integrate China into the global financial system.
Experience suggests that simultaneous liberalisation and opening up of fragile financial systems often ends in vast crises. If the country concerned is systemically important, such crises will be global. Floating exchange rates may weaken the impact. Even so, a crisis in a systemically important economy will have huge effects.
For this reason, the opening up of China's financial system to the world must be regarded as a matter of global concern. A recent paper from the Reserve Bank of Australia illustrates some risks. A significant aspect is the potential for a vast increase in two-way flows of portfolio capital, which are still modest from and to China.
At present, controls on outflows remain tight. But consider some relevant magnitudes: China's gross annual savings were about US$5.2 trillion (S$7 trillion) last year, against US$3.4 trillion in the United States; its stock of "broad money", the widest measure of the money supply, was US$15.3 trillion at the end of last year; and the total gross stock of credit in the economy was about US$30 trillion.
China is the savings superpower.
It is not hard to envisage a huge gross outflow, due to portfolio diversification and capital flight, should controls be lifted. Against such vast potential outflows, foreign-currency reserves as large as US$3.2 trillion would be swiftly exhausted. While there would also be foreign portfolio demand for Chinese assets, the domestic policy and institutional changes needed to make that a reality are likely to be impossibly demanding.
It is probable, then, that the impact of capital account liberalisation would be a large net capital outflow from China, a weaker exchange rate and a bigger current account surplus. Weaker investment would reinforce this. It is hard to imagine how such a shift could be accommodated. One needs only to think of possible impacts on asset markets, exchange rates and current account balances in the rest of the world economy.
In her speech at the China Development Forum this month, Ms Christine Lagarde, managing director of the International Monetary Fund, noted rightly that "increased global integration brings with it greater potential for spillovers - through trade, finance or confidence effects. As integration continues, effective cooperation is critical to the functioning of the international monetary system. This requires collective action from all countries".
Right now, nothing is more important than the cooperative management of the immediate stresses in the Chinese economy and the longer-term challenges of China's financial integration.
If either were to be mishandled, it could put unbearable pressure upon our integrated global economic system. The world economy is still struggling to handle the aftermath of the Western financial crises. It might fail to cope with a Chinese one altogether. The last time a hegemonic financial power emerged, the world suffered the Great Depression. It has to do better this time.