Bracing for the next big financial crisis

China would play an even greater role should the global economy crash again

China's economic stability is essential to its development. This stability depends greatly on its central bank, the People's Bank of China, which issues money, monitors the banking system and ensures that the supply and cost of Chinese money is in line with steady economic growth and a sensible exchange rate against the currencies of its main trading partners.

It's a complicated job, part science and part judgment, which the PBOC shares with the central banks or currency boards of all other countries. Above all the central banks, including the PBOC, stands the Bank of International Settlements in Basel, Switzerland, which oversees the activities of national banking and monetary systems. The integration of markets and economies in a globalized world has given the BIS an increasingly important role in providing global financial stability.

In 2007, the year before the financial crash, the BIS warned that the global financial system was becoming overstretched, and that the banking systems in the developed world were coming under pressure. But although the BIS has great influence, it does not have the power to compel any central bank. It can advise and warn, but it cannot give orders, and it does not issue its own money. As we know, the Federal Reserve Bank of New York and the European Central Bank in Brussels did not act on the well-timed warning from the BIS.

Against that background, you would expect today that if the BIS issued another warning, the world would pay attention. At the end of June, BIS general manager Jaime Caruana gave a speech at its headquarters that contained a strong note of caution: "A new policy compass is needed to help the global economy step out of the shadow of the global financial crisis The global economy continues to face serious challenges. Despite a pickup in growth, it has not shaken off its dependence on monetary stimulus Instead of adding to productive capacity, large firms prefer to buy back shares or engage in mergers and acquisitions. And despite lackluster long-term growth prospects, debt continues to rise."

In his speech, Caruana blamed the continued dependence by the advanced economies, led by the United States, on ultra-loose monetary policy in place of the necessary deep-seated structural changes. Those changes can release new economic energy and revive stagnant Western economies, but they are unpopular and politically difficult. Caruana compared the steady fall in productivity to the rise in debt, which has reached 275 percent of GDP in the advanced economies. To maintain or improve living standards, increasing debt is compensating for falling productivity, in the view of the BIS.

Caruana's warning was reinforced by William White, head of the Economic Review and Development Committee at the headquarters of the Organization for Economic Co-operation and Development in Paris. As one of the very few experts who accurately forecast the 2008 crash, while head of research at the BIS, White's words are listened to with respect around the world.

In a recent interview, he said, "Risk-free bond rates are at enormously low levels, spreads are very low it all looks and feels like 2007. And frankly, I think it's worse than 2007, because then it was a problem of the developed economies. But in the past five years, all the emerging economies have imported our ultra-low policy rates and have seen their debt levels rise. The emerging economies have morphed from being part of the solution to being part of the problem."

But the US Federal Reserve Bank, the controller of the dollar-based global economy, does not agree with the BIS or William White. Several days after Caruana's speech, Fed Governor Janet Yellen made it clear that she does not think that extremely low interest rates were the main culprit in the 2008 financial crisis, or constitute the main problem now. In her opinion, monetary policy should not concern itself with soaring bond, equity and real estate prices. She prefers, she said, to rely on well-regulated and financially strong financial institutions to withstand financial shocks, and operate a loose monetary policy that supports household spending and economic growth in the United States.

The disagreement between these two powerful financial institutions, the BIS and the New York Federal Reserve has increased the risk that markets will crash as interest rates rise. Can China's stability withstand another financial crash? Or would China emerge stronger? With a share of the world economy at 16 percent this year, and 19 percent in five years' time (using IMF purchasing power estimates), China's ability to withstand global financial turbulence has become a vital matter for the rest of Asia, if not the world.

Chinese exports would be hit by a Western fall in demand. But its nonconvertible currency and still mostly closed financial markets give China protection against a financial storm in developed markets. Most importantly, in contrast to the advanced economies, China's program of deep structural reform, as outlined at last year's Third Plenum, makes it increasingly robust with regard to external shocks, by strengthening China's domestically generated growth and economic independence. The government's encouragement of new private-sector-based industries like e-commerce is a vital part of this effort to renew and strengthen China's economy, which is undergoing the process of fundamental change that advanced Western countries need but can still only talk about.

China certainly has economic problems in the well-publicized overhang of local government debt and the overheating of its real estate market in certain areas, much of which follow from its reaction to offset the 2008 crash. But the forward-looking, courageous determination of its government to grasp now some important nettles in its economic reform program will make it a key part of any solution to another Western financial crisis.

With the BIS and the US Federal Reserve Bank on opposite sides of the argument about global financial stability, the likelihood of another global financial crisis grows. But next time would indeed be different, because Western taxpayers would refuse to pay for another huge bank bailout, as they did in 2008-09.

The emerging world, led by China, is economically in a much stronger position relative to the advanced countries than six years ago, with the world economy split between the two in terms of size (using purchasing power calculations). Although in 2009, China may not have expected its sudden promotion to world power status, the country's emergence since the crash as a global pillar of growth has significantly increased the country's global influence.

Another crash on Wall Street would reinforce the attraction of the renminbi as a store of value and anchor of stability for other regional currencies. It would also provide attractive acquisition opportunities for China in advanced economies, which till now have resisted Chinese investment, as in the case of Huawei's thwarted attempts at expansion into the US market.

It would underpin China's global appeal as a peaceful force for stability in a volatile and troubled world, and hasten the re-engineering of shareholding in the major organizations of global governance, particularly at the World Bank and the IMF. Prepared or not, in the event of another crash China would find itself in a position of even greater global leadership and responsibility than today.

The author Giles Chance is a visiting professor at Guanghua School of Management, Peking University.