If the US subprime mortgage crisis worsens and pushes the American economy into recession, what should Beijing do? That is the $64,000 question many businessmen and investors are asking. The financial markets in Greater China have already priced in an eventual 'growth recession' in the US. That is, many players expect the growth rate of America's gross domestic product to slow, perhaps significantly, but to remain positive. On the assumption that this relatively rosy scenario is true, investors have focused instead on expectations of negative real interest rates in Hong Kong, sending the Hang Seng Index into record territory. Similar thinking is also driving mainland China's soaring share prices. The People's Bank of China has raised interest rates five times this year, but inflation is higher than deposit rates and moving up faster. Thanks to the mainland's already negative real interest rates and undervalued currency, liquidity remains abundant in its stock markets. But what if the US economy stops growing and slides into an outright recession, as shell-shocked American homeowners pull back on spending? Fears of such a scenario were apparently what prompted the US Federal Reserve to slash its benchmark interest rate by 50 basis points on September 18. Investors from New York to Shanghai breathed a sigh of relief, but bear in mind that the Fed's room for further action might be limited, given rising inflationary pressures from a weakening US dollar and record oil prices. If Americans consume less, the knock-on effect on the Chinese economy - with its high exports-to-GDP ratio - should not be underestimated. About one-third of Chinese exports, including re-exports from Hong Kong, end up in the US. According to many analysts, a 1 per cent reduction in Chinese exports to the US would mean a 1.2-1.4 percentage point decline in the rate of China's GDP growth. In other words, the Chinese economy has hardly been 'decoupled' from America's. In fact, the mainland may be about to become even more coupled to the economic jitters unleashed in the US. It has taken a bold step to open its capital accounts wider - by proposing a scheme that allows individual mainland investors to buy Hong Kong equities. This, however, means that the mainland's overvalued domestic equity market will be more exposed to sudden swings in the risk appetite of global investors, many of whom take their cues from Wall Street. Chinese policymakers will not sit idly by if the US economic engine splutters. In theory, China could devalue its currency to make its exports more competitive, or lower interest rates to stimulate domestic demand. But, in practice, these would hardly be the best moves. Imagine the uproar if the yuan weakened just as US politicians were clamouring for an unrealistic revaluation of the Chinese currency. Neither is a blanket ideal for monetary or fiscal stimulus. Any central bank interest rate cuts would incur the risk of rising inflation and widening income gaps - bank deposits are the biggest source of poor people's earnings from savings. True, Beijing has more leeway for stimulating the economy. In the first half of this year, government revenue rose more than 30 per cent from the same period last year. But government spending must also be thought through more carefully, as it is currently extremely skewed towards industrial and infrastructure investment, as well as civil servants' salaries. Instead, the government needs to spend more on providing public benefits like health care and education. Regardless of the external environment, the future sustainability of the mainland's economic growth depends on its ability to spark a domestic consumption boom. The key to achieving this is to reduce significantly the country's high savings rate. (The fact that large, state-owned enterprises are being forced to give dividends highlights policymakers' awareness of the importance of cutting even the corporate savings rate.) But as long as people feel they need to squirrel away big chunks of their incomes for their own retirements and their children's education, consumption will continue to be held hostage to savings. Thus, the best solution to the mainland's over-saving problem is more government spending on public services without raising taxes. The next-best options are tax cuts for both individuals and enterprises. For example, the personal income tax exemption could easily be raised to 2,000 yuan or higher. Also, the next logical step - following the recent unification of the corporate income tax rates for local and foreign companies at 25 per cent - is to lower it even further. Beijing could do so many things to unleash domestic demand in response to a US recession. But none would be as effective and beneficial over the long term for the mainland economy as meaningful reform in the financing of the country's own public sector. Steven Sitao Xu is the Economist Intelligence Unit Corporate Network's director of advisory services in China
