China holds the key to the next phase of the financial crisis. Falling oil and food prices will come as a relief to Western policymakers, but the reality is that the West has already more or less run out of policy options—at least easy ones. They are now largely in “cross fingers and hope for the best” territory—where the best largely depends on emerging market central banks, which do still control their own destiny. In particular, that puts the focus on China, which has important choices ahead.
China needs to decide whether to persist with its policy of monetary tightening now that it is beginning to yield results. Growth has now slowed for four consecutive quarters to 10.1% from a peak of 11.9% and is forecast to fall to around 9% next year—a decline that would feel akin to a recession in a country that needs to create millions of jobs for an expanding urban population.
Meanwhile, inflation fell back to 7.1% in May, having peaked at 8.7% in February.
The optimistic scenario is that China sticks with its current monetary policy, using bank required reserve ratios rather than interest rate hikes to take some of the heat out of the domestic economy. A slowing Chinese economy would reduce demand for oil and other commodities, leading to lower global inflation. That would pave the way for lower Western interest rates, easing the pressure on Western financial institutions.
But there are two major risks to this scenario. The first is that China tries to ease some of the domestic pain by allowing the renminbi to appreciate. The country’s long-standing policy of holding down its currency—thereby sacrificing consumption to job creation—has led to the build-up of China’s vast trade surplus, stoking its inflation problem. Over time, further appreciation of the currency seems inevitable. But too fast an adjustment could trigger a global loss of confidence in the dollar and dumping of dollar assets.
The second risk is that China succumbs to domestic political pressure and abandons monetary tightening. Earlier this week, the finance and economic committee of the National People’s Congress called for policymakers to be flexible and guard against a sharp slowdown, fuelling speculation over a change in policy.
Such a shift would be a major shock, raising fears that an overheating China would start pushing oil prices back up again, dashing hopes of a quick recovery from the financial crisis.
For the moment, China looks committed to continuing to fight inflation, while allowing only gradual appreciation in the renminbi. But the country has a choice—and will exercise that choice in the interests of domestic politics rather than global investors. The rest of the world will have to live with whatever it decides.