Is Osborne making a mistake in China?

Earlier today, George Osborne delivered a speech in Shanghai in which he looked forward to a “golden era for the UK-China relationship.” Among the ideas put forward in the speech was the decision to connect the London and Shanghai stock exchanges, meaning that Chinese cash will flow into UK markets—and vice versa—in an arrangement described by Osborne as a “win for China and Britain.” This comes in the wake of the recent announcement that Chinese investment will be used to develop the Hinkley Point nuclear Reactor in Somerset, a sign that Britain and China are drawing ever closer in their financial and investment relationship.

There is a logic to this courting of China by Osborne. China is a vast surplus country and Britain a deficit nation. If Chinese capital could be better deployed in London's financial markets or on the Somerset coast, then—well—why not?

Osborne's Chinese overture involves deep risks. There is concern among senior economic analysts that the Chinese economy is dangerously flawed, and that government reforms are weakening it further. China's economy has typically been based on exports, allied with high levels of government spending. More recently, the government has tried to change this, by encouraging private enterprise in the hope that Chinese consumers would earn more, spend more and boost domestic demand. But as the government has lowered levels of infrastucture spending, growth has slowed dramatically, from a pre-crisis peak of around 14 per cent to a rate now estimated at 4 per cent (Chinese economic data are issued by central government, and so considered questionable.)

Willem Buiter, the Chief Economist at Citigroup recently published a paper on China. His remarks were unequivocal: “We believe that there is a high and rising likelihood of a Chinese, emerging market and global recession scenario playing out.” Buiter puts the probability of a global recession in the next 18 months, driven by Chinese weakness, at 55 per cent. The worry, he says is that a recession, beginning in China, could spread among other emerging economies, many of which are already in recession, such as South Africa and Brazil. Russia is also in an acute phase of economic weakness, brought on by cripplingly expensive wars and the low oil price, which has diminished the value of its energy exports. The decline in commodity prices has hurt all emerging economies. If China were to weaken and slip onto recession, other emerging markets would weaken even further. This would trigger a series of competitive currency devaluations, as countries competed to make their exports more attractive by lowering the value of their currencies. This string of devaluations could depress the global economy, ultimately causing it to slip into recession.

This sense of alarm is shared by other senior economists, one of whom agreed that “something nasty might be brewing,” in emerging markets, which escaped recession in 2008-10 by allowing a credit bubble to develop. It was this new reliance on credit that was behind the so-called “taper-tantrum,” of 2013, when emerging markets, hooked on credit, panicked when Ben Bernanke suggested that the US was going to slim down—or “taper”—its quantitative easing programme. If there were to be a sudden slowdown, said one senior economist, “the fallout will be much worse in the emerging markets, but it would still be nasty in the developed markets—a bit like the Asian meltdown of 1997-98.” It is an unhappy comparison.

In a note published on September 15th, Barclays reported the findings of a survey of 716 global investors, reporting that: “more than 40 per cent of investors now see weak China/Emerging Market growth as the main risk to financial markets over the next 12 months.”

Westminster figures are also beginning to talk with alarm about this economic threat, one remarking on the worryingly low levels of liquidity in global markets—a sign that investors are running low on ready cash. It was the absence of liquidity that drove the banking crisis of 2008. When liquidity dries up, financial markets cannot operate.

This calls into question the benefits of creating such direct and intimate economic and financial links to China—especially to its stock market, which in recent months has experienced bouts of extreme volatility. China has traditionally had no social security net, and citizens are encouraged to put their savings into the stock market. They have done so with enormous enthusiasm: China's equity market is now valued at $8.1 trillion. There are now more Chinese investors in China's stock market—90m—than there are members of the Chinese Communist Party—87.8m. Chinese investors have access to online leverage websites, where they can borrow against current holdings in order to invest yet more, making Chinese investors some of the most leveraged in the world. It is even possible to use homes as collateral, a mechanism that creates a link between China's stock market and its booming housing sector. The result of this free-for-all has been eye-watering losses, as in August, when the Shanghai Stock Exchange startled world markets with a series of dives that wiped one third off its value.

Osborne's speech today was a moment of political success for the Chancellor, who burnished his reputation as an international statesman in a way that no other candidate to succeed David Cameron could hope to emulate. There are expert analysts who do not believe that China is heading for trouble—it is to be hoped that they are correct. But if China's economy does sink into recession, dragging the global economy down with it, then the Chancellor's warm words today could soon turn to ashes in his mouth.