The fourth global economic risk centers on China, the second locomotive of the present and potential global expansion. Nicholas Lardy notes in chapter 4 that it became the third largest trading nation in the world in 2004, has already become the second largest importer of a wide range of commodities from cement to oil, and accounted for over 20 percent of the entire increase in world trade during 2000–03. China’s worldwide impact derives not only from its size and rapid growth but also from its openness to the global economy; its ratio of trade to GDP is double that of the United States, European Union, or Japan, and its ratio of inward foreign investment to GDP is even larger by comparison.

It is thus of great global consequence that China faces the risk of a substantial slowdown of its own economy. The country must rein in its recent runaway credit expansion and unsustainable levels of investment, with growth slowing as a result. The new political leadership that took office in late 2002 refused to address the problem for more than a year. It finally did so via a peculiar mix of market-related policies, such as higher reserve requirements for the banks and modest interest rate increases, and traditional command-and-control directives such as sectoral ceilings on increases in bank lending.

Under the best of circumstances, China’s growth will have to drop for a while from the 9 to 10 percent pace of recent years. When the country cooled its last excessive boom, after 1993, the rate of growth declined for six straight years (figure 1.2). Atruly hard landing, due to the delay in addressing the problem and the half-measures initially adopted, could be much more abrupt and severe. Either outcome will dampen growth in all of East Asia (including Japan) and, via commodity markets and other trade effects, significantly affect the rest of the world.