Menace of the China syndrome

IT was an unwitting symbol of our time. Shortly after the September 11 attacks, a patriotic keychain went on sale in the US with 'God Bless America' emblazoned across the Stars and Stripes. Just underneath were the words: 'Made in China.'

While the Bush administration fights a war on terrorism, US Federal Reserve chairman Alan Greenspan and other central bankers have been engaged in a battle of their own. They are trying to prevent the rise of China and other emerging markets from destabilising Western economies - including ours.

Since the mid-1990s the Chinese economy has doubled in size, helped by an artificially low currency that makes exports even cheaper abroad. Its production ranges from steel and coal all the way to computers, mobile phones and electronic components. The country dominates the toy industry.

New factories rise monthly along the coast of the East China Sea and the banks of the Yangtze River. Shanghai has become the world's biggest building site.

Britain's imports from China have risen 40% in two years. For the first time, they last month matched imports from Japan. America has long passed that milestone. And the trend is accelerating. China last year became the world's top destination for foreign investment. The country shrugged off last winter's Sars epidemic.

From Thailand to India to Lithuania, other emerging economies are also expanding again. Call centres are springing up in Bombay. Glossy brochures for West End estate agents are being put together in Africa, then emailed and printed here. Soho fashions are manufactured on the Baltic.

Technology and falling tariffs allow ever greater amounts of work to be sourced to countries where wages are low, workers are keen, and health and safety regulations rather less intrusive.

If all this seems far removed from events in Britain, it isn't. This process is good for consumers, but worrying for the economy overall. It is destroying two things in the West: prices and jobs.

Thanks to the 1990s investment boom, there is already huge overcapacity in most industries. Developing countries are adding yet more, forcing producers into a price war to sell their goods.

So despite record low interest rates, and a modest economic 'Baghdad bounce', inflation remains at bay. Under EU measures, in Britain it is just 1.1%. The picture is the same across the West. Central bankers are on guard against damaging, Japanese-style deflation.

Meanwhile, jobs are flooding to the developed world like a tsunami. In two years, China has gained at least 2m manufacturing jobs, while the US has lost 2m.

Central bankers have resorted to modern alchemy. By slashing mortgage rates, they are turning bricks and mortar into cash. As house prices rise, homeowners refinance and spend.

Since early 2000, the Bank of England has slashed rates from 6% to 3.5%. Mortgage equity withdrawal rose 75% to £42bn last year. It is forecast to hit £53bn in 2003. The US figure in 2002 was £150bn.

If this bicycle stops, we fall off. In the US it has started wobbling. Mortgage refinancing has slumped this month, following a sudden, sharp rise in long-term borrowing rates.

Bijal Shah, strategist at SG Securities, says: 'The Fed is getting very worried. The rise in long-term rates is choking off refinancing, and that was the one thing keeping the US consumer going.'

The Federal Reserve has to talk long-term rates back down. In a barely noticed remark to the US Senate, Greenspan said the market had overestimated his optimism. Last week, he unleashed two Federal Reserve board members to say interest rates will not rise, and could go as low as zero. Meanwhile, the Bush administration is urging the Chinese to revalue their currency upwards.

Bush's advisers fear further rising unemployment ahead of next year's election. A recession did for Bush senior's re-election hopes 12 years ago. Expect interest rates to go lower across the board.