Is China insulated from the World Trade Centre Attack?

Will chaos in the US following the terrorist attack on the World Trade Center impact China? Analysts are divided

"Markets usually recover pretty fast from catastrophes like these. The US is going to ensure there is enough liquidity in the system, and China's economy is relatively insulated," comments Sean Xu, managing director at Beijing-based investment bank China International Capital Corporation (CICC).

Such is the view from China on what America is terming the 'first war of the 21st century'.

The impact of the terrorist attack on New York and Washington earlier this week has been minimized by China's closed capital account, say analysts, and the country's relatively self-contained domestic market. 

Investors are not free to buy mainland-listed companies, apart from the hard currency B-shares, which are usually issued by companies in addition to their local currency listing. The yuan is not freely convertible and is pegged at an unofficial level of around 8.3 to the dollar, preventing destabilization by volatile capital flows.

Some analysts are seemingly unconcerned about the impact of the attack. 

But Chinese shares trading in Hong Kong have had a less reassuring reaction. The Red-Chip Index and the H-share Index plummeted 12.42% and 7.58% respectively last Wednesday, the day following the attack, with the red chip index falling even further than the broader 33-stock Hang Seng Index which itself fell 8.87%. 

However, this could have been due to a sell-off of none-core holdings by institutional investors, according to Herbert Lau, head of research at Celestial Asia Research.

"When institutional investors are selling, they get rid of their weaker stocks first, and red chips are not as attractive as blue chips such as HSBC Hldgs," he notes. 

Of greater concern is whether or not the World Trade Center attack will depress China's high growth rate, considered vital for the country's political stability.

China's GDP came in at just under 8% for the first half of this year, but Premier Zhu Rongji announced in March that growth rates could average a less exciting 7% over the next five years after China's accession to the WTO, scheduled for the second half of next year. This view is based on the expectation of a dramatic increase in domestic bankruptcies and unemployment as China restructures its companies under pressure from foreign competition.  China's growth has averaged 8.3% for the last five years. 

There is also a concern that the attack could worsen economic frailty amongst China's largest trading partners Japan, and its largest export market, the U.S. But Andy Rothman, CLSA Securities China Strategist is relatively optimistic.

"Exports are only 20% of China"s GDP, in contrast to 50-100% across much of Asia, and anyway net export growth has not contributed much to GDP for the last two years," he says.

Economic growth has been driven by domestic demand, which itself is driven by fiscal stimulus spending to the tune of $20 billion per year, Rothman adds. He, therefore, believes government would respond with more pump priming measures to keep GDP growth at around 7% if weakening overseas demand required it. 

But some analysts believe China is more susceptible to a global downturn than Rothman's scenario suggests.

"China is already well integrated in the global trading system, and is more sensitive to a global economic downturn than many imagine. If you take total trade  - rather than just exports - at around $400 billion, it comprises 36-38% of China's GDP, whereas in Japan, usually considered an export superpower, total trade is only around 20% of GDP," says Fred Hu, managing director of  Asian economic research at Goldman Sachs.

It is therefore not correct to say that China's domestic economy, however large, can prevent a global economic downturn from affecting China's growth rate, he comments. 

"In addition, China's net exports, at 3-4% of GDP, show a negative trend compared to last year, and this will drag down Chinese GDP growth rates," he notes. 

China's budget deficit as a percentage of GDP has doubled over the last three years and the government cannot afford to repeat that over the next three years, Rothman warns, which is why the government is so determined to go ahead with WTO-backed reforms and the development of the private sector. 

Japan has been China's largest trading partner for the last seven years, but Japan may have been hardest hit by the attack as it comes at a time when reformist Prime Minister Koizumi is restructuring the economy. The most recent figures show the economy contracted in the second quarter of this year by 0.8%, while the benchmark Nikkei Index dropped to its lowest level in almost 20 years in the aftermath of the attack. 

These factors, together with decreasing exports from foreign invested enterprises in China (which account for half the country's exports), have led to estimates that China's export growth could slow to as little as 5% this year, compared to 28% last year. 

China's increasing imports are threatening the country's balance of payments, although China's balance of payments should be helped by the foreign investment, which came in at $41 billion last year. 

CLSA's Rothman, in line with other analysts, therefore estimates that China will maintain a modest current account surplus in the near to medium term.

Higher oil prospects could, however, hurt growth prospects since China imports around 30% of its oil supplies.

Ironically, oil prices in China are now set at world levels after price mechanisms were deregulated in line with the privatisation of PetroChina and Sinopec, thus exposing the economy to the full impact of higher world oil prices.

Oil prices could rise higher still if the US undertakes any military action in the Middle East, although Dong Tao, China Economist at investment bank CSFB, believes demand has weakened with the global cyclical downturn.

"We don't see oil prices trending higher, although that could change if the US goes to war in the Middle East," he concludes. 

But oil prices, at around $28 for Brent Crude - one of the benchmark crude oil prices - are historically already very high, thanks to a very disciplined approach to oil production by the Organization of Petroleum Exporting Countries. In the early 1990s prices hovered around $20-22 per barrel, contributing to the global recession of the time. 

"Even if the US just slaps sanctions on Iran, Iraq or Libya, rather than going to war, oil prices could stay at $28" points out David Johnson, regional oil analyst at JPMorgan, Hong Kong. 

China' s economic miracle is looking more fragile by the day. 


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