Party coming to an end for pair of economic drunkards

There is not much in the current world financial crisis to be grateful for, but one small mercy is that it has silenced all the nonsensical talk about economic decoupling.

About time, too. The overriding trend of the last 10 years has been towards globalisation. Supply chains have gone truly international. Manufactured goods are now commonly assembled from components sourced from half a dozen different countries before being shipped halfway around the world to their final customers.

Financial markets, too, have become intercontinental, with vast flows of cross-border capital channelled around the world in an unending search for the most attractive risk-adjusted returns. In this environment, ideas about decoupling - in which one part of the world economy, like the United States, could slip into recession, leaving other bits, like China, unaffected - always sounded more like wishful thinking than joined-up economic theory.

If anything, events like the weekend's bailout of American mortgage guarantors Fannie Mae and Freddie Mac have underlined just how closely intertwined the Chinese and US economies have become this decade.

Each year, American consumers have bought hundreds of billions of US dollars worth of Chinese-made goods, helping to fuel the export boom and export-led investment surge that have together propelled China's astonishing pace of economic development.

In return, each year the mainland lent America hundreds of billions of US dollars from its export earnings, holding down long-term interest rates and helping to finance America's consumer spending and housing booms - directly finance in large part, with the People's Bank of China holding close to US$500 billion in bonds and asset-backed paper issued by Fannie Mae and Freddie Mac.

They need each other. The US and China are like a couple of drunkards reeling crazily down the pavement in a tight embrace. Without the vital prop of the other to lend support, each would slump helplessly to the ground, unable to remain upright any longer.

The charts below showing the composition of US and Chinese gross domestic product illustrate how the two economies complement one another. The first shows how the US has become ever more addicted to personal consumption, which last year exceeded 70 per cent of total GDP. In contrast, net exports were negative.

The second shows how the mainland economy has increasingly become hooked on exports and investment, which last year together made up half of total output, with household consumption lagging far behind.

The party was great fun while it lasted. The problem now is that time has been called. The bar has closed and the drunks have been ejected on to the street.

All those cheap Chinese funds helped inflate a massive property and debt bubble in the US. With house prices now down 20 per cent from last year's peak, the bubble has well and truly burst. US consumers and financial institutions alike have now entered a brutal period of deleveraging which is crushing economic activity.

On the mainland, the picture is different although scarcely less daunting. The era of growth at all costs is coming to an end. A stronger yuan, higher raw material and energy costs, stricter environmental standards, rising wages, softening external demand and a tumbling stock market are all squeezing corporate profits. Together with tighter credit conditions, that means less money for private-sector investment in the future, putting the brakes on the key driver of mainland growth.

This is not the end of the world. Both economies will adapt: the US by consuming less and saving more, China by spending more money at home and investing less in export industries.

But the transition will be painful. The two drunks will continue to lean on each other for a while longer. But no matter how hard they try to keep the party going, their binge has ended and the hangover is about to begin.

Maybe it's time to think about decoupling now.