The earthquake and subsequent tsunami and nuclear meltdown in Japan have profoundly impacted global financial markets. Their effect on the Chinese economy is fourfold – as follows:

Trade links with China

China has become Japan's top trading partner, accounting for 20 percent of Japan's total exports and imports. But Japan is only China's third largest trading partner. Consequently, a short term fall in Japanese demand will not have a major impact on China. China's imports from Japan are mainly high-tech inputs to its auto, machinery and electronics production. They are likely to fall in the short-term as Japanese manufacturers shut down domestic production lines after the earthquake. But the disruption of trade is likely to be relatively minor as the disaster-hit areas are in traditional farming areas, not industrial belts. Intra-firm supplies to Japanese companies operating in China and Japan could be affected, but the impact may well be concentrated in specific areas such as telecoms equipment, chemicals, and machinery. However, given that the affected region only accounts for a small proportion of Japan's industrial output, the economic impact will remain limited.

Another effect of the earthquake is that some orders originally placed with Japanese manufacturers will switch to China. For example, after the mass closure of Japanese steel mills, China's number one producer of silicon steel, WISCO, raised the prices of its cold-rolled grain-oriented sheet. Chinese steel mills will also benefit from the 10 percent easing of iron ore prices caused by the lack of demand from Japanese mills. In future, Chinese companies may receive many orders originally destined for Japanese manufacturers.

Capital flows

Japan's earthquake is likely to trigger repatriation of funds by Japanese households and corporations selling offshore assets and from re-insurance flows. Their counterparts will witness corresponding capital outflows. From China's perspective, the biggest impact should be on the FDI front, as China generally allows little portfolio investment. From the latest data, inward FDI outstanding from Japanese companies totaled $68 billion by the end of 2010, second only to that of US firms. But this amount is extremely small compared with China's FX reserves of $2.8 trillion. As such, any capital outflows should have little impact on China's economy. In fact, capital outflows will help relieve pressure on the RMB exchange rate, a positive factor from the central bank's point of view.

Impact on bulk commodities

Japan's strong demand for infrastructure-related raw materials for reconstruction will stimulate demand growth in related industries in China. Industries with excess capacity such as the steel industry will benefit from the reconstruction.

However, this will also trigger price increases in bulk commodities such as iron ore, coking coal, thermal coal and natural rubber. Given China's demand for bulk commodities, the risk of imported inflation is a problem that will need to be addressed.

Influence on Chinese monetary policy

Despite the uncertainties in the global economy caused by events in Japan, the People's Bank of China (PBOC) still raised the reserve requirement ratio for large financial institutions by 50 bps. The move demonstrated that PBOC does not think Japan's triple disaster will derail the global economic recovery. It also shows that the central bank is thinking ahead and determined to stay ahead of the tightening curve in combating inflationary pressures.

Currently, the PBOC's 1-year central bank bill auction yields are already 20bps higher than the 1-year deposit rates, suggesting that an interest rate hike is already in the pipeline, as it opens an arbitrage window to the market. The PBOC will probably raise its policy rates twice, each time by 25bps, in the second quarter of 2011. Meanwhile, a gradual RMB appreciation of up to 6 percent will continue regardless of any possible strengthening of the Japanese yen.

The author is head of China Economic Research at ANZ.

Opinion articles reflect the views of their authors, not necessarily those of China.org.cn.