The world is flat

This is certainly the fear in export-dependent countries such as Japan. Treasury Secretary Henry Paulson called French Finance Minister Omi, who then convened other top financial officials. They came to the sad conclusion that Japan’s growth policies will have to be changed to meet the new world conditions. According to big bank Mitsubishi UFJ Financial, the collapse of the U.S. housing bubble and its effect on the yen and the Nikkei stock index means real growth will fall 0.8 percent over the next six months (to March 2008). The bank assumes a drop in the Nikkei to 15,000 and a rise in the dollar/yen (USD/JPY) to 111.00 to 112.00. (The pair was trading around 116.00 in early September.)

In recent months, there has been talk of the rest of the world disengaging from U.S. economic and financial leadership. It is no longer true, some say, that when the U.S. sneezes, the world catches cold. But this is wishful thinking. If Japan is deeply worried about the knock-on effects to its own economy, shouldn’t China be equally worried?

China seems to be in its own little world, isolated from developments everywhere else. The Shanghai Composite stock index keeps rising regardless of other world stock markets, or even China’s own rate hikes. China is the third or fourth largest economy in the world, depending on how you count, not to mention the holder of the biggest stash of official reserves. A major slowdown in the U.S. would have a huge effect on Chinese production, employment, and so on.

This is the true potential effect in Asia (rather than outright losses and a domino effect), since most Asian financial institutions have little direct exposure to American subprime. But it may take several months for a slowdown in U.S. imports from China to have a big effect, and in the meanwhile, the U.S. Congress is hurling insults at China over trade practices and (especially) the level of the yuan. And China is hurling back. Most observers expect the new $200 billion Chinese “sovereign wealth fund” scheduled for launch in late August to head straight for non-U.S. assets.