Subject: The China cycle - FT Analysis (IMPORTANT) - PLEASE READ - Political Risk on Global Scale
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Date: Tue, 14 Sep 2010 12:16:06 -0400

World economy: The China cycle
By Geoff Dyer
Published: September 12 2010 20:03 | Last updated: September 12 2010  
20:03

Allied by alloys: a steel market in the Chinese privince of Hubei. As  
well as investing in fellow emerging nations' commodities, such as  
Brazilian iron ore, Beijing is increasingly investing in their  
infrastructure
Deep in the Amazon jungle, huge chunks of red earth are torn out of  
the ground at Carajás, the biggest iron ore mine in the world, to be  
transported halfway round the globe to the steel mills on China’s  
eastern seaboard. There they are turned into the backbone for millions  
of tower blocks in hundreds of booming Chinese cities.

Last year, China overtook the US to become Brazil’s biggest trading  
partner. The two large developing countries may be on opposite sides  
of the planet but their growing economic ties over the past decade  
have become among the enduring symbols of shifts in the global economy.

The duo could also be forging a path for one of the potential biggest  
realignments in the global economy over the next decade. With little  
fanfare, China is likely to emerge as the biggest direct investor in  
Brazil this year, following a string of deals announced in mining,  
steel, construction equipment and electricity transmission.

Such investments are part of a slow-burning but hugely important  
trend. Newly crowned the second-largest economy, eclipsing Japan,  
China is becoming the anchor for a new cycle of self-sustaining  
economic development between Asia and the rest of the developing world  
– one that is bypassing the economies of Europe and the US.

China is not only sucking in raw materials from other developing  
economies, just as it has during the past decade. It has also begun  
making investments in infrastructure and industry in those countries,  
some of which are made possible by its cut-price and increasingly  
sophisticated manufacturing companies or by the attractive financing  
terms it can offer. Beijing has for some years been investing in this  
way in parts of Africa: now such deals are being rolled out around the  
world. For many developing countries, the impact of the China boom is  
coming full circle.

“It is the start of a new cycle,” says Ben Simpfendorfer, an  
economist at RBS and author of The New Silk Road, a book on the  
surging economic ties between China and the Middle East, central Asia  
and south Asia. “China has companies that are willing to invest, they  
have products that are good enough, and they are backed by abundant  
liquidity in the country’s financial system.”

BEIJING MEETS BRAZIL
●Direct investment overseas by Chinese companies has increased from  
just $5.5bn in 2004 to $56.5bn last year. Chinese officials predicted  
last week that it would reach $100bn by 2013.

●About 70 per cent of the money invested last year went to other  
parts of Asia. Latin America came in second place with 15 per cent.

●Chinese companies have so far invested only very modestly in Brazil  
but Brazilian officials estimate that investment will exceed $10bn  
this year.

●Chinese banks have lent $10bn to Petrobras, the Brazilian oil  
company, and $1.23bn to Vale, the iron ore miner.

Ian Bremmer, president of the Eurasia consultancy and author of the  
recent book, The End of The Free Market, says there is no accident to  
this China-led process of decoupling from the west. It is, he says, a  
strategy to reduce economic – and to some extent political –  
dependence on the US.

“It is a very conscious policy, on the top of the agenda for the  
entire Chinese leadership,” he says. “They are looking for a  
hedging strategy because they feel uncertain about the long-term  
economic prospects of the developed world.”

Promoting innovation and stimulating domestic consumption are also  
part of that strategy, he argues, but pushing stronger economic  
integration with the rest of the developing world is the “one  
strategy that can be done quite quickly”.

Nowhere is the impact of this process being felt more keenly than in  
Brazil.

As trade has boomed with China during the past decade, Brazilians have  
sometimes complained of being relegated once again to their 20th- 
century role of providing commodities to the industrial powers. In the  
past year, however, the long-awaited wave of Chinese investment in the  
country appears finally to have reached Brazil’s shores. While it  
reached only $92m in 2009, the country’s officials estimate that it  
will exceed $10bn this year.

Wuhan Iron and Steel, for instance, paid $400m for a stake in a mining  
company owned by Brazilian industrialist Eike Batista, and is planning  
to build a huge steel mill beside the port near Rio de Janeiro that  
another of Mr Batista’s companies is constructing. Lifan, one of  
China’s biggest manufacturers of motorcycles and cars, already  
exports heavily to Brazil. Now the company’s founder, Yin Mingshan,  
says it is considering opening a plant to build cars in the country.  
“Brazil is a very promising market, with a vast territory and a big  
domestic market,” he says. “Some Chinese businessmen are foolish  
enough to ignore doing business in Brazil but I am not that stupid.”

If investment in Brazil is one symbol of this new stage of economic  
Chinese engagement with the developing world, another is the flurry of  
new rail networks taking shape globally. Chinese railway construction  
companies are some of the most efficient anywhere, and have for  
several years been operating in neighbouring countries in central and  
south-east Asia. But in the past year they have also signed contracts  
in such diverse places as Ukraine, Turkey and Argentina.

Chinese companies in the sector have not restricted their activities  
to the manual task of laying rail lines. They are hoping to start  
signing overseas deals to sell high-speed rail equipment, including  
locomotives and signalling systems. The first customer could be the  
planned high-speed line between São Paulo and Rio de Janeiro.

There are two factors that have made these new links possible. The  
first is that China has produced a generation of companies making  
capital goods that are now internationally competitive. They can offer  
developing countries new trains, power stations, mining machinery and  
telecommunications equipment of sufficient quality at prices that are  
often well below those of their multinational competitors.

GLOBAL RENMINBI USE
‘It’s like a Formula One starting race, everyone jostling for  
position’
Although China is both the second- largest economy and the biggest  
exporter in the world, the renminbi is virtually unseen outside the  
country. For global transactions, China depends on foreign currencies  
– in particular the US dollar.
The perils of this arrangement became clear during the financial  
crisis, when China’s mighty export machine was hit by a freeze in  
dollar-denominated trade credit. So in recent months Beijing has  
unveiled measures to facilitate the use of the renminbi and reshape  
the global monetary system. “We’re at the beginning of something  
huge,” says Dariusz Kowalczyk, a Hong Kong-based strategist at  
Crédit Agricole. “Intermediation through the dollar will be  
gradually eliminated.”
In June, Beijing expanded the scope of a year-old pilot scheme for  
settling cross-border trades in renminbi, opening it up to the world.  
Global banks such as HSBC, Deutsche Bank and Citigroup have since been  
encouraging companies from London to Tokyo to use the Chinese currency  
rather than the dollar. Some even offer discounted transaction fees as  
an incentive. “It’s like a Formula One starting race –  
everyone’s jostling for position,” says Philippe Jaccard of  
Citigroup.
The financial infrastructure is now in place to allow an Argentinian  
grain producer, for example, to sell goods for renminbi then use the  
proceeds to buy farm machinery from China. Cross-border trade in  
renminbi totalled Rmb70.6bn ($10bn) in the first half of the year. But  
that figure remains tiny compared with the $2,800bn worth of goods and  
services traded across China’s borders last year, most of which was  
settled in dollars or euros.
One of the obstacles to greater global use of the renminbi is a lack  
of ways for foreign companies to invest their renminbi or hedge their  
exposure to the currency. Strict capital controls place China’s  
financial markets almost entirely off limits. But that is changing.  
Last month, China opened its domestic interbank bond market to foreign  
central banks and commercial banks that have accumulated renminbi  
through cross-border trade settlement. Curbs on the free flow of  
renminbi in Hong Kong have also been lifted. Since July, financial  
groups in the special administrative region have been able to create a  
range of renminbi-denominated investment products and hedging tools –  
all open to global companies and investors.
McDonald’s, the US fast-food chain, last month became the first  
foreign multinational to issue a renminbi-denominated bond in Hong  
Kong. It plans to use the proceeds to fund its operations on the  
Chinese mainland. Robert Cookson

The second element is the financial backing from a banking system that  
has been mobilised to follow behind these businesses. Yi Huiman, a  
senior executive at Industrial and Commercial Bank of China, told a  
conference recently that the institution was working with the  
government to provide “railroads plus finance” around the world.  
Vale, the Brazilian company that operates the giant iron ore mine in  
the Amazon, announced on Friday that it had signed a $1.23bn credit  
with two Chinese banks to finance the purchase of 12 huge cargo ships  
from a Chinese shipyard, which will transport iron ore between the two  
countries.

The scale of these transactions is clearly much smaller than  
Beijing’s holdings of US securities, estimated to be in the order of  
$1,500bn, but the underlying dynamic is the same: the Chinese  
financial system is starting to recycle some of its holdings of  
foreign currency into the economies of its developing country trading  
partners, in order to stimulate demand for its own goods.

The impact is already apparent in China’s trade statistics, with the  
biggest increases in exports in the past year coming from developing  
countries. Trade with the Association of Southeast Asian Nations  
increased by 54.7 per cent in the first half of the year, and by 60.3  
per cent with Brazil.

If Chinese investment does indeed help to kick off a growth cycle in  
other parts of the developing world, it will be a tonic for a global  
economy in which the outlook for many leading economies remains  
subdued, with some even facing the risk of a double-dip recession. The  
combination of Chinese demand and booming investment is one reason for  
Brazil’s ability to record China-style growth rates of 8.9 per cent  
in the first half of the year.

Yet for western economies there are also plenty or risks involved. The  
investment push is likely to herald an era of intense competition  
between developed-world multinationals and state-owned Chinese  
companies. The strong financial backing that such groups receive is  
also likely to fuel accusations that they are not playing on a level  
field. It is perhaps no surprise that some of the multinationals that  
in recent months have publicly voiced criticisms of Beijing’s  
industrial policies – GE and Siemens – operate in sectors in which  
China is becoming a fierce competitor, such as power equipment and  
railways.

China’s new clout is also raising questions about the future of the  
dollar. Chinese officials have talked about a long-term goal of  
replacing it as the global reserve currency with a basket of others,  
potentially including the renminbi.

As trade with the developing world balloons, Beijing has also been  
taking important steps to expand the international use of the  
renminbi, including allowing overseas holdings of the currency to be  
invested in the onshore bond market. Some economists believe it could  
become the reference currency for Asian trade over the course of the  
next decade.

Yet the irony is that, while there is strong economic momentum behind  
the Chinese currency taking on a much larger international role,  
Beijing is reluctant to let this happen. “China is still very  
hesitant about whether it really wants the currency to be  
international,” says Yu Yongding, an influential economist at the  
Chinese Academy of Social Sciences think-tank.

To become an important trading currency is one thing: but to become a  
global reserve currency with the power to threaten the role of the  
dollar, the government would need to lower capital controls and open  
up its domestic bond market. This would mean giving up its tight  
control of exchange and interest rates.

Furthermore, if economic integration with other developing countries  
is really to take off, it will require careful management by Beijing.  
There is a very real risk that the new-found interest in emerging  
markets will provoke a backlash, especially if China’s exports of  
manufactured goods keep up such a rapid pace of growth.

There are already plenty of warning signs. India, for instance, has  
tried this year to reduce supplies of Chinese power equipment in  
favour of goods made by local producers. For several months, New Delhi  
blocked Huawei, the Chinese maker of telecoms equipment, from the  
Indian market.

In Brazil, there are fears that companies such as carmaker Lifan want  
to use the country to assemble kits of nearly-completed cars made in  
China rather than promote a domestic industry. There is also concern  
about fresh competition for access to markets elsewhere in Latin  
America. Kevin Gallagher of Boston University calculates that 91 per  
cent of Brazilian exports of manufactured goods to the region are  
under threat from lower-priced Chinese products. If that market wilts  
away, industry is likely to become much more critical of the new China  
ties.

China’s growing links with the rest of the developing world could  
provide a huge boost both to the country itself and to the global  
economy during the course of the next decade. But a wave of  
protectionism could yet halt the process. Beijing will need to work  
hard to ensure its new partners in the developing world do not feel  
steamrollered by the Chinese juggernaut.