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China weathers the global storm

It was a potent symbol of a new world order on Tuesday when China raised interest rates for the fourth time this year in a desperate attempt to cool an overheated local economy. The move comes at a time when central bankers in the West are wondering whether they should be cutting the cost of borrowing to stave off a potential economic downturn caused by the current credit crisis.

The People's Bank of China increased the lending rate by 18 basis points (1.8 percentage points) to 7.2 percent arguing there was a need to "reasonably control credit growth and to stabilize inflationary expectations," but the move was also clearly designed to stall the continuing stampede into the red-hot Shanghai stock market.

The Chinese and some other Asian exchanges have been immune to the storms that have sent equity prices in New York and London into a downward spiral and the Far East economic boom has saved many Western stocks from falling much faster and further than they would have done without it.

Even so, some financial analysts are now beginning to question how long the world's most populous nation can continue to bail out Europe and the US before it too gets dragged into the mire as it raises interest rates further or finds demand for its goods slowing down in the US. Previous stock market crashes have often started in Asia or seen the region pull down global asset prices. But the current strength of China and other developing economies has set a different tone.

METALS DEMAND

Andrew Milligan, head of global strategy at Standard Life Investments, points out that in the last sell-off in 1998 on the back of Russian bond defaults and the collapse of the LTCM hedge fund in the US, the world economy was performing quite badly.

"Japan and Asia were in a recession and industrial production growth across the world was really rather weak. This time round the US is not doing so well, but China and emerging markets have been doing really rather well. The world economy has got this safety net, this cushion of Chinese, Russian and Middle Eastern demand which is supporting activity for exporters in Europe and the US," he said.

China's growing industrial success has been built on providing everything from cut-price fridges and televisions to toys for Western, particularly US, consumers. A big downturn in spending at malls in Chicago will immediately impact on factory production in Shenzhen.

The China boom over the last few years has triggered a large increase in demand for raw materials sending the price of metals upwards and boosting the stock prices of companies such as miners and shipping firms.

Raw materials such as tin and nickel have reached record levels this year while stocks traded on the Shanghai exchange have risen by 85 percent this year and put on 30 percent of that in the second quarter of the year when markets were starting to crumble elsewhere.

By contrast, the Dow Jones Industrial Average of US stocks is up by 5 percent so far this year and the FTSE index of the leading 100 companies in London is down by almost 3 percent and the Nikkei in Japan by 7 percent.

Those figures mask the true scale of the upheaval in recent weeks since banks and other lenders began to admit their exposure to defaults in the US' high-risk subprime mortgage market. In the last six weeks the FTSE 100 has fallen by 9.4 percent while the wider market is down by a similar amount. Over the same period the Shanghai composite index has gone up by more than a quarter, boosted by continuing optimism.

Optimism in China has helped stop further falls in London. Although the price of metals has fallen -- copper has dropped from US$7,910 a tonne to US$7,005 over the last fortnight and nickel has slipped from US$31,100 per tonne to US$26,000 over the same period, mining experts say the damage would have been much worse without China's huge commodity purchases.

John Meyer, at Numis Securities, says the price of commodities is coming down from ultra-high levels.

"Whenever you get major uncertainty like that you see currently in the stock market, commodity prices and mining stocks tend to be heavily hit. There is no doubt commodities would have suffered much more if it had not been for China," he said.

MINING

Big mining houses such as BHP Billiton have seen their share prices plunge by 20 percent since early June but Meyer points out that the stock had risen by 20 percent before that on the back of ever-more optimistic forecasts about physical demand from countries such as China.

Investors tend to flee from commodities and mining stocks on the assumption that demand will be hit by a stock market downturn that could be followed by a wider reduction in economic growth.

Mining firms are also seen as risky because they are traditionally affected by the pronounced cyclical nature of the metals markets which have become more volatile in recent years because of large speculative buying.

But on Tuesday, Arjan Palthe, senior portfolio manager of the ABN Amro Funds, argued that any companies with continuing exposure to China and other developing countries could benefit from the current stock market turbulence.

"In China there is a boom in infrastructure and factory building. Considering the economic expansion there, this industry [supply] group is likely to continue providing excellent returns for a number of years," he said.

Gold is one commodity that traditionally follows a less turbulent path because it is seen as a safe haven for investors along with cash and government bonds.

Spot gold prices increased by US$2 per troy ounce on Monday and Numis Securities has been recommending those mining houses close to the sector such as Peter Hambro, Randgold Resources and Celtic Resources.

Karen Olney, chief European equity strategist at Merrill Lynch, argued in a research paper entitled Fear versus Fundamentals that investors should hold their nerve.

"We think equities are the right place to be, although it will be a volatile ride over the summer if terrifying headlines continue to fire-up investor worries," she said.

The outcome of current global credit worries continues to be uncertain, but the fate of China is bound to have a big influence on the outlook for the world economy.

Milligan says that some of the confidence built into current optimistic assessments of the risk to the wider global economy is based on an assumption that, for the time being, China is not going to make any major policy mistakes.

That situation could change if it was felt in a few weeks that the Chinese economy was overheating and Chinese authorities had to raise rates again, dampening demand for commodities and other goods, he said.

"The Chinese authorities have difficult balancing acts. It's not impossible despite all the action taken already that come the autumn the [Chinese] authorities feel they have to take more aggressive action to bring the economy to heel. We still have to keep a watchful eye on China," Milligan said.
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