Are we really entering a "golden" relationship with China?

Drum roll. President Xi Jinping is in town for a state visit, and we are going to make him feel very welcome. He is staying at Buckingham Palace, he will address Parliament and he will hold meetings with both major parties' leaders. But why is he coming here of all places?

The last time a Chinese head of state came to London on official business was in 2005, when Xi's predecessor Hu Jintao came. Back then, there were prickly demonstrations by human rights protestors, but the government gave Hu the red carpet treatment, even bathing iconic London buildings and landmarks in red light at night. This week, Xi will be treated with even more reverence—ostensibly quite surprising given that China's most important peers or priorities are the US, Japan, Russia, India, and in the EU, Germany. But our bilateral relationship has been getting stronger just as China's relationship with the US has been getting more strained, with disputes over computer hacking and limits on US firms’ access to Chinese markets. Senior US politicians are wondering why the UK is cosying up to a country that is already its geopolitical rival.

It comes as no surprise that the British government has been looking for opportunities to get access to China's markets and its capital, bearing in mind the still delicate economic situation the country is in, and the government's strategy to push the fiscal deficit into surplus by 2020. Similarly, it shouldn't be a surprise perhaps that China has been making overtures to the UK: it is, after all, a close friend of the US, and it also retains a relatively liberal approach to business and commerce among EU member states. What is new in the UK-China relationship is something the Chinese value a great deal, namely the ability of London to shore up Beijing's desire to "internationalise" the Yuan. We should also note that the circumstances bringing the UK and China closer together, notwithstanding a fractious history from China's perspective, also point to political uncertainties about which both countries need to be, and are doubtless, aware.

Since Hu Jintao's state visit a decade ago, China’s GDP has grown about four times, while the UK's GDP has risen a mere 40 per cent. China's share of world output has almost doubled to 17 per cent, while the UK's share has shrunk from 3 to just over 2 per cent. Hundreds of companies are doing business in China nowadays. The British government has declared that it wants to make China its second biggest trade partner over the next 10 years, and is keen that the UK's £19bn deficit in goods and services with China will narrow over time. UK motor vehicle manufacturers, for whom China is the largest export market, have been doing very well, and will hope that rising per capita income in China lifts car ownership levels to European levels eventually. But auto sales are quite cyclical, and have been off colour in China of late, and so it is important for other UK exporters to try a lot harder.

Also since 2005, China's foreign investment in Europe via acquisition has grown from small scale to substantial. At $18bn in 2014, China's investment still pales next to that in Asia. But it has been growing quickly, not least in the UK, which now receives about a third of China's annual flow of investment in the EU, and a similar proposition of the stock that has built up since 2000. And it looks as though these trends will continue because China has become more partial to foreign investment as as major balancing item to offset its trade surplus. Until recently, the major balancing item was the relentless accrual of currency reserves, invested in now low-yielding US and European government bonds, for example. Building capacity overseas through investment is seen as more productive and also helps to relieve chronic overcapacity in construction, heavy industry and traditional manufacturing industries at home that is leading to growing deflation and bad debt problems.

Recent publicity has centred on a number of projects and initiatives in which the British government has engaged with China or will seek to do so. These include, for example, the Hinckley Point nuclear power station, the One Nine Elms development in London, the HS2 rail project, possibly the mooted HS3 across the Pennines, and newer Northern Powerhouse ideas that George Osborne talked about on his recent visit to China. Some people have raised security issues over China's involvement in nuclear technology in the UK but the British government is unlikely to be deflected.

The newest bind between the UK and China, though, has centred on matters of finance. The UK was the first major developed nation to back China's setting up of the Asian Infrastructure Investment Bank earlier this year, much to the annoyance of the US. This Bank, along with another institution called the New Development Bank, or more colloquially the BRICS bank, form part of China's grand political and commercial strategy, known as One Belt One Road. This 21st century recreation of the old Silk Road links across central Asia to the Middle East and Europe. It would, if successful, be China's geopolitical imprint on the global system. It is too soon to say whether this is, as the Chinese might say, loud thunder and small raindrops, or something more substantial, but either way, it will spur construction, and hopefully, business opportunities for global, including UK, companies.

A parallel goal in these Chinese initiatives is to have the Yuan become a significant currency on the world stage, where it might edge out the US dollar's primacy as the denominator for a wide range of transactions. London is already on course to become an agent of this objective. China has given its blessing for London to become the premier financial centre outside Asia for Yuan trading, clearing and settlement facilities. An extension of currency swap facilities with China was recently announced, along with a study to connect the Shanghai and London stock exchanges, and an agreement to allow the issuance of Yuan-denominated bonds, including by the Chinese government, in London. Progress in these areas should help the Yuan become more widely used, and fit China's goals and London's objectives.

It would be wrong to imagine, however, that a more robust commercial relationship is a trouble-free beginning to what has been called a "new golden era." China, for example, might be forgiven for wondering what might become of this relationship if the UK chose to leave the EU in the upcoming referendum. It is by no means clear that it would consider the UK its preferred EU destination for foreign direct investment. The UK's economic prospects would be uncertain, to say the least. The economic advantages of being in the EU might be compromised or lost. Regulatory changes might confer business advantages to banks domiciled in the eurozone to London's detriment. Brexit would most likely trigger the resignation of David Cameron and set in motion new and perhaps unpredictable political developments, which might well make the UK a less desirable place for China to deploy its capital and reputation.

Similarly, the UK may be angling for a tighter commercial relationship with China, which makes 21st century sense, but can it afford to lose sight of China as a country lacking in transparency and one that has explicitly rejected "western values?" We should remember that President Xi is not only managing China during a difficult economic period, but also doing so while pursuing a political strategy that is a throwback to the days of Mao Zedong, before government institutions substituted for the power and authority exercised by a single leader. He is on a mission to "purify" the Communist Party by making it more disciplined and compliant. But this mission is also having a negative effect on an economy that was bound to slow down and struggle anyway with excessive levels of debt and industrial capacity. The anti-corruption campaign is perversely frustrating economic reforms, and leading to policy inertia and resistance. No one knows which way Xi will turn. He could taper the anti corruption campaign and incur his citizens' frustrations, or intensify it and incur his opponents' wrath. The British government cannot raise these highly sensitive domestic issues but needs to be alert to the political volatility that might reflect on commercial relations.