What will go wrong next?

The worst outcome in the current economic crisis would be a Chinese devaluation. The last devaluation of the renminbi yuan in 1994 allowed China to undercut rival Asian exporters and paved the way for the current problems. A further weakening would almost certainly take the Hong Kong dollar with it and renew the downward pressure on other Asian currencies. The feared rerun of 1930s-style competitive devaluations around the world would be unavoidable.

But a weaker renminbi is a tempting option for China's leaders facing internal financial and economic difficulties. Quite simply, China's banks are insolvent and 50% of state-owned enterprises (SOEs) are losing money.

The government is committed to reforming the banks and the SOEs but it needs a healthy, growth economy to absorb the pain. That it doesn't have. China's economy is slowing down and projected 8% to 9% growth rates are unachievable. Consumer prices declined by 0.4% in October ­ a remarkable event in a large developing economy like China's ­ prompting deflation fears. Direct foreign investment ­ an impressive $140 billion over the past four years, 20% of GDP ­ is also declining. Out of an 850 million workforce, 150 million are unemployed and reform of the SOEs could add another 50 million to the total. This is a political time bomb in China where unemployed workers roaming the country in search of work are causing social problems.

"China has tried to solve its problems in the traditional Asian way by exporting more," says Michael Howell, managing director of investment advisory firm CrossBorder Capital. "China is failing to create jobs and must have sustainable growth. One way to get this is by reducing the value of the currency."

The impact would be felt worldwide. With its low-cost labour, China can produce most standard goods cheaper than rivals and in vastly greater quantities. Devaluation magnifies this advantage. China's trade surplus, currently $30 billion, would go on rising and the resulting US-China trade imbalance would bring the two countries head to head.

Global overproduction, the root cause of the current malaise, would get much worse.

China's economy is partly insulated from the world economy, which is why the government may feel dumping exports is the easiest solution to its difficulties.

Unless the IMF or the G7 persuades China to rethink, a fatal blow could be delivered to dwindling prospects of containing the crisis in Asia. Instead, China needs to boost domestic demand. The policy dilemma is that this can best be done through the SOEs, which analysts have been advising China to slim down.

Global deflation without a cure

Even if China doesn't devalue, the waves of Asian deflation will spread across the world bringing down stock markets and currencies. Excess capacity has built up over the past two decades and cannot be cut back quickly.

The knee-jerk reaction of governments is to erect trade barriers against the incoming tide of cheap goods and to devalue the currency to make exports cheaper. This brings temporary relief to one country but worsens the global situation. The solution is demand management, but international bodies like the IMF have not yet addressed this. It's an unfashionable concept and grasping the nettle is made more difficult because current policy-makers have never had to deal with a situation like it.

"Asia is the epicentre of global deflation," says Ed Yardeni, chief economist with Deutsche Morgan Grenfell. "There are just too many goods chasing too few consumers on a global basis. In the worst case competitive devaluations could push everybody deeper and deeper into the hole."

And that includes the US and Europe. Yardeni has lowered his forecast for US GDP growth in 1998 from 3% to 2% and says it could flatten out if things got even worse. Similar forecasts have been made by other economists for Europe and Japan. In prospect is a global recession fitting for a global economy. But the transmission mechanism will not be trade but poor performance from multinationals (see next section) hitting stock-market valuations. Either way the impact of the Asian crisis on the US is unlikely to be "modest but not negligible", as suggested by Federal Reserve chairman Alan Greenspan. It's going to be major.

Overproduction is unprecedented - the world car industry has capacity to turn out 35% more vehicles than required; huge inventories of computer chips pushed down prices last year by 80%; Japan alone has built manufacturing capacity across Asia three times larger than French industrial output; China makes 30 million TV sets a year, about a third of world production; China and Korea produce more steel than the US and the UK added together.

The economic catch-22 is that the low wage costs making Asia the workshop of the world are not conducive to developing a domestic consumer market. Car ownership, for example, starts at a per capita income of $6,000 a head. Chinese incomes are one-tenth of that and Indonesia's one-sixth. On current growth trends it will take 30 to 50 years before Asia is wealthy enough to consume its own output.

There is a consumer crisis in the developed world, too. Unemployment may be at contemporary lows in the US and UK (though not in Germany and France) but income distribution has become more uneven and there is a huge underclass in both countries. While low-income consumers don't have the ability to increase their spending, higher-income ones - a bigger proportion of total demand than two decades ago - have the option to spend or save. If the outlook is bleak they will decide to save or pay down debts.

A curious price phenomenon could arise in big service economies such as the US and UK. Tight labour markets, rising wages and low productivity gains could result in inflation in services while manufacturing is hit by deflation. Monetary authorities might raise interest rates to squeeze out service-sector inflation and thereby exacerbate worldwide deflation.