Like it or not, China's economy is to a large extent driven by foreign demand. Without seriously considering this factor, we cannot make a sound assessment of our economic future.

From 1998 to 2001, the contribution of demand from overseas markets to economic growth was slipping. Accordingly, the economy was bogged down in a deflationary trap.

But between 2002 and 2004, soaring exports helped the national economy achieve average annual growth of more than 9 per cent.

Demand from foreign markets has thus become an important leverage for the economy. It would be unwise to forecast the trajectory of the Chinese economy without reference to foreign demand.

Past changes in foreign investment in developed economies are useful indicators with which we track the movement of China's foreign demand.

In the United States, which is a major market for Chinese products, the 77 per cent slump in foreign direct investment (FDI) it suffered in 2002 came at the same time as dramatic rises in China's exports to the United States and China-bound FDI. That year, China saw its exports to the US rise by 29 per cent, and FDI jumped by 20 per cent. China replaced the United States as the leading FDI destination.

Despite that unexpected contradiction - it was generally believed at that time a weakening US economy would lead to slashed imports from China - most economists took the contiguity to be a coincidence.

Actually, the influence of FDI was at work. The decline in FDI flowing into the United States affected employment and ultimately consumer income. Americans therefore tended to purchase cheaper commodities, and inexpensive Chinese products soon began to be favoured.

According to statistics from the US Department of Commerce, from January to July 2001, US commodity and service imports increased by 0.4 per cent while imports from China rose by 2.2 per cent. This indicates demand from US consumers for Chinese products was increasing.

In the past six months, the US dollar has been rising steadily while the euro weakens. This is closely related to two indices released in June in the United States. The Institute for Supply Management index of manufacturing activity rose by 58.8 per cent and the Michigan Consumer Sentiment Index was up for the first time this year. The changes in the indices point to a stronger US economy.

Last year, FDI flowing into the United States also rebounded, rising to US$121 billion from US$31 billion a year before. It recovered its top spot lost to China two years ago. China attracted US$62 billion in FDI last year. The shift has important implications.

In 2002 the slump in capital flow into the United States, coupled with fallout from the 2001 terror attacks and uncertainty over global petroleum production, led to the huge trade deficit. The counter-terrorism wars also helped worsen its fiscal balance sheets. The dual deficits led to a plummeting US dollar, which made Chinese products even more competitive since the renminbi is pegged to the US dollar.

As the clouds of war over Iraq disperse, there are less uncertainties in the US market, attracting much-needed capital.

American consumers have enjoyed seeing their wallets fattened thanks to the increase in inflow of FDI. They have become less sensitive to prices when purchasing commodities.

How should we assess the impact of the changes in the US economic climate on the Chinese economy? Should we be alarmed by these trends, which may bring about weakened demand for Chinese products?

In the report released by the State Information Centre on China's economic activity in April, it was suggested that as economic growth relies heavily on foreign demand while domestic demand is comparatively weak, the State should properly control the expansion of exports.

However, if we take into consideration weakened demand for inexpensive Chinese products as a result of rising FDI flow into the US market, we will find we need not bother worrying about rising exports for the time being.

What we should examine is whether dropping demand from the United States would be offset by increased demand from other arenas. If there are no alternative markets, we must be prepared in advance for a possible economic downturn, because deflation is a much larger problem than inflation in China.

Demand from the European Union may plug the gap left by the United States.

In the past two years, China's exports to the EU have risen dramatically. In 2003, the growth rate was 50 per cent and last year, it was 37 per cent. The EU replaced Japan as China's largest trade partner last year. The United States and Japan were the second and third largest respectively.

The root causes are similar to those that caused a shift in the wake of the September 11 terror attacks. In the 2002-04 period, the EU's FDI influx slipped for three consecutive years from US$374 billion to US$169 billion.

The plunge resulted in falling employment and income inexpensive Chinese products became more popular. This explains the increase in Chinese exports to the EU this year.

Demand from overseas must not be ignored. Since EU demand for Chinese products seems to be offsetting the impact of reduced US demand, it is too early to forecast whether the economy will continue to storm forwards, or begin to be held back.

(China Daily July 22, 2005)