Special investigation by City staff – Telegraph.co.uk Nov 29, 2007
Towards the end of September, a group of the world's most powerful bankers met for an emergency summit on the credit crunch which, days earlier, had threatened to topple Northern Rock, Britain's fifth-biggest bank.
All those present knew about the extraordinary scenes on the UK's high streets as thousands of savers queued for days to withdraw more than £10bn of their savings in the country's first run on a bank since Victorian times.
But while banking and investment executives elsewhere in the world had watched the TV pictures with a sense of horror, those who gathered in the spartan meeting room 5,700 miles from London had another word at the forefront of their minds: opportunity.
For this was not London, New York or Frankfurt, but Shanghai. And the senior officials from communist China's central bank who had convened at the People's Bank of China that day knew that the crisis in the global financial markets had served only to hasten the transfer of economic power from Europe and the US to Asia.
For a decade, China has deliberately insulated itself against the boom and bust cycles of the capitalist West by building up the greatest cash fortune ever assembled: a staggering $1.3trillion (£650bn) in foreign exchange reserves.
China's colossal war chest reflects its emerging status as a superpower challenging the West not only economically but politically, with potentially profound implications for us all.
In this, the final part of our series on the worldwide credit crunch, we examine where the global economy goes from here, and probe how the balance of power is shifting from West to East.
The total secrecy in which the Chinese state conducts all of its business means that the meeting of central and commercial bankers at the People's Bank of China in Shanghai, the country's commercial capital, has never been reported. Officially, the Chinese government and the state bank will not even confirm that it happened.
But The Daily Telegraph has been exclusively briefed on the discussions, which gave a rare glimpse of the workings of the communist regime and its financial operations.
Those present included senior executives from some of China's "Big Four" commercial lenders, each of which has the government as its majority shareholder. Officials from the People's Bank of China wanted to know whether the lending banks "had any skeletons in the closet", according to one person present.
Had they, in other words, bought any Western loan packages whose value could be affected by the global "credit crunch" which had been sparked by America's sub-prime mortgage crisis?
By and large, the answer was "no". The insider said: "There was a debate which drew one general conclusion: that China's capital walls had largely insulated the country's banking sector from the crises elsewhere.
"There may have been a feeling of vindication, but there was not one of complacency."
Strict regulations on the flow of money into, and out of, China meant that the contagion spreading across the rest of the world's financial markets would have little direct impact on the world's most populous country.
Weeks later, China's economic ascendancy was neatly illustrated when Bear Stearns, one of the US banks worst affected by the sub-prime mortgage crisis, was forced to go cap in hand to a major Chinese brokerage to secure a cross-shareholding agreement which would put it back on its feet.
Economists are in no doubt about the long-term implications of the credit crunch.
"Has this sped up the transfer of the mantle of economic superpower from West to East? Quite simply, yes," said Peter Spencer, chief economist for the Ernst & Young Item Club.
"We've seen a flight [of money] to East Asia in recent months. The US economy is in a terrible jam now, with a falling housing market and a weakening economy."
Mr Spencer added: "The US and UK economies are heavily based on financial services. Our governance depends on things like credit ratings agencies for financial products and accountants for financial statements. When you have a shock like Enron, which raises doubts about the latter, and the credit crunch, which raises all sorts of questions about our system of financial regulation, it clearly makes us less attractive from the point of view of investors."
China's trillion-dollar cash reserves are managed by three of the most powerful women in the world, known as the three Xiaos.
They are Wu Xiaoling, 60, the senior deputy governor of the People's Bank of China, Hu Xiaolian, 49, who is in charge of foreign exchange, and Zhang Xiaohui, who directs monetary policy. (To further confuse matters, the male governor of the bank is named Zhou Xiaochuan).
When Wu Xiaoling, a cheerful-looking woman who typically wears a plain white blouse and bulky blue suit, was appointed president of the Shanghai branch of the People's Bank of China in 1998, Asia was in crisis.
The Asian debt bubble had just burst. Thailand, Indonesia, Malaysia and their neighbours were facing steep recessions after Western investors pulled out their money. China quickly learned from the experience and began building up its vast cash reserves, largely held in US Treasury bonds, under the guidance of the three Xiaos.
Nine years on, the policy is reaping its rewards. While the West faces a serious slowdown, if not a recession, as a result of the credit crisis, the Chinese economy is growing stronger by the week. The markets in Shenzhen and Shanghai have climbed to record highs more than a dozen times in the space of a month.
Wu Xiaoling's reward for her shrewd financial stewardship is a modest government salary of around £250 a month.
But entrepreneurs who have flourished in China's booming economy are rather less abstemious. In 2006, the country had 22 billionaires, according to the respected Forbes Magazine. Today there are 66.
The Shanghai stock market has risen 300pc since January and PetroChina, the state-owned company which listed its shares on the Shanghai stock exchange this month, is valued at more than $1 trillion, dethroning ExxonMobil as the world's most valuable company.
A British banker who owns part of a faux-leather goods factory in the Pearl River Delta reports that because of this frenetic financial activity, inflation is rising in China. "We've raised prices three times this year and not bothered to export because demand is so strong within a 100-mile radius of our factory," he says.
A similar story is unfolding in the booming economies of Brazil, Russia and India (they, together with China, have been given the acronym BRIC by economists).
The British banker worries that China and the other BRIC countries will end up exporting inflation to the West. The risk, he says, is that the Bank of England and the Federal Reserve in Washington won't then be able to cut interest rates if the Western economy stops growing.
This is but one of half a dozen nightmare scenarios for 2008 and beyond being advanced by pessimistic economists.
Others include crude oil rising above $100 a barrel and acting as a brake on the world economy; the dollar's fall turning into a collapse that generates a new round of panic; the risk of a political shock like a US strike on Iran, and a failure of Western economic policymakers to co-ordinate their actions, leading to a 1987-style stock market crash.
Optimists point out that over the past five years the world economy has grown strongly. The International Monetary Fund forecasts that the credit crisis will cut 2008 global growth only marginally - from 5.2pc to 4.8pc - while the UK economy grows at a sluggish but satisfactory 2pc or more. But the official forecasts could prove over-optimistic if the banking system continues to be dragged down by the credit crisis.
While "things have improved significantly since August", Bank of England governor Mervyn King said in a BBC interview earlier this month, risks remain.
"There is always in a period like this the possibility that a shock from outside the UK, one from the world economy, might create further fragilities," he said.
The UK may be more vulnerable than other countries if the decade-long boom in house prices turns to bust.
The International Monetary Fund calculates that UK house prices have risen 50 per cent more than they should have in the past decade.
Vincent Cable, acting leader of the Liberal Democrats, says banks have been guilty of irresponsible lending by offering mortgages of up to six times salary.
"Four years ago, I warned Gordon Brown that we were heading for a dangerously unstable position based on excessive and irresponsible lending," he said. "Mr Brown told me I was 'generating alarm without substance'."
All the while, however, Northern Rock was allowed to carry on with its high-risk strategy of borrowing massively to fund more and more mortgages - a policy which proved disastrous when banks stopped lending to each other.
As the regulator of individual banks, the Financial Services Authority bears a degree of responsibility for failing to spot the riskiness of Northern Rock's strategy. FSA chairman Sir Callum McCarthy and chief executive Hector Sants have both acknowledged this.
But while the FSA could have done more to regulate Northern Rock, its powers do not extend to the international markets in which the credit crunch has its roots.
Interviewed shortly before he became chairman of Citigroup (which changed its leader after it, too, was caught out in the sub-prime mortgage fiasco) Robert Rubin, Bill Clinton's Treasury secretary, told The Daily Telegraph that more regulation was needed.
"What caused the mispricing of risk? Human nature," Mr Rubin said. "There's something that drives people toward excesses. The key is to let free markets operate, but to get the balance right."
Mr Rubin believes that in dealing with financial bubbles (and the consequences when they burst), "the right policy response is to deal with each crisis as it comes along. What do you do to temper risk-taking? It's not a mainstream view, but my view is that you take steps to make it so people can't borrow so much. How do you do this? You put in place capital requirements, margin requirements".
In the 1920s, individual Americans went on a binge, buying shares on margin - that is, borrowing as much as 90 per cent of their cost. In October 1929, when the US stock market started to fall, these investors were forced to liquidate their holdings to pay back what they owed. The downward financial spiral helped to precipitate the Great Depression.
Between 2002 and 2007, banks were buying bonds on margin - borrowing more than 90 per cent of the cost to pay for their investments. In August, when parts of the bond market collapsed, the spectre of 1929 began to haunt the world's major banks.
So far, the British economy appears to have had a narrow escape. Northern Rock savers did not lose any money as a result of the bank run, and although British banks are expected to write off millions as a result of their exposure to their sub-prime mortgage crisis in the US, and shareholders in the Rock have suffered losses, the UK financial system as a whole has held.
Opinions are divided on whether the weakness in the financial system will lead to a recession or whether the resilient broader economy will ultimately restore confidence.
We can be certain, however, that the three Xiaos, and their counterparts in the emerging Asian economies, will have plenty of say in our future.
Reporting by Peter Koenig, Gordon Rayner, Katherine Griffiths, James Quinn, Mark Kleinman, Edmund Conway, Jonathan Sibun, Philip Aldrick, Andrew Porter, Robert Winnett, James Kirkup and Iain Dey.
Last updated 13/12/2007