China's influence on the world economy

China is fast emerging as an important player in the world economy, as reflected in its recent appearance at the G7 meeting. The latest edition of The Economist has a feature on China. The excerpt reproduced below touches on an effect that China has that is, in my opinion, not recognised by many.

Economies can get truly richer only through increased productivity growth, either from technological advances or from more efficient production thanks to international trade. Thus China's integration into the world economy genuinely creates wealth. The same cannot be said of all the "wealth" produced by stockmarket or housing bubbles.

In recent years, many people around the world have found it easier to make money from rising asset prices than from working... But much of this new wealth is an illusion... rising house prices do not represent an increase in wealth for a country as a whole. They merely redistribute wealth to home-owners from non-home-owners who may hope to buy in the future. Nevertheless the illusion of new-found wealth has caused households as a whole to save less and spend and borrow more.

Historically low interest rates have fuelled housing bubbles in America and many other countries around the globe. At some stage prices will fall, obliging consumers to save much more and spend less. The unwinding of America's vast economic imbalances could depress growth there for many years, whereas China's slowdown looks likely to be fairly brief.

Oddly enough, China may be partly to blame for this wealth illusion in rich economies, because central bankers have been slow to grasp the consequences of China's rapid integration into the world economy. By producing goods more cheaply and so helping to hold down inflation and interest rates in rich economies, China may have indirectly encouraged excessive credit creation and asset-price bubbles there. Inflation has remained low, but excess liquidity now flows into the prices of houses and shares rather than the prices of goods and services. And to keep its exchange rate pegged to the dollar, China has been buying vast amounts of American Treasury bonds, which has helped to depress bond yields and mortgage rates, fuelling America's property boom.

The Economist appreciates the profound influence the Chinese economy already has on the rest of the world, particularly in fomenting asset bubbles. But the magazine is hardly alone. Morgan Stanley chief economist Stephen Roach, for example, has been talking about global imbalance -- global consumption being concentrated in the US, global production and investment being concentrated in China and the rest of Asia -- for a long time. And even as many other economists continue to debate over the reason for the decline in 10-year bond yields over the past few months despite rising federal funds rate, Roach, like The Economist, appears to be quite ready to point the finger at China (and Asian central banks in general, as I discuss in "Explaining the fall in bond yields").

Truly, it is becoming impossible to explain or forecast macroeconomic developments without taking China into account, as the G7 now well understands.