China is suffering from the recession in the Western economies. Demand for its exports is sharply contracting. How China weathers this storm is crucial to global recovery. There are also important lessons from the boom and bust for how international economic co-ordination can be improved. Debt levels in the Western economies need to be unwound and savings ratios increased. Conversely, China must make efforts to stimulate domestic demand. Its single-minded pursuit of export-led growth in this decade has contributed to stresses in the world economy that have now spectacularly burst open.

The economic thinking of China's officials in the past decade has been shaped by the Asian currency crisis of 1997 to 1998. The experience convinced them of the need to build up foreign exchange reserves, so as not to be vulnerable to similar speculative attacks. From 2000 Chinese exports consistently grew by 20 per cent each year. About a quarter of Chinese GDP growth is attributable to the expansion of the trade surplus.

China's financial system was not sufficiently developed to provide an outlet for the surplus of savings. Consequently those savings were recycled in the Western financial system - specifically in dollar-denominated assets such as US government bonds. There were two main consequences for Western economies. First, cheap Chinese imports moderated the pace of inflation. Second, an abundance of capital invested overseas by Chinese institutions ensured that central banks could maintain interest rates at low levels.

These developments appeared to be beneficial. They contributed to the long expansion of the Western economies, with low inflation and easy monetary policy. Chinese savings invested abroad allowed the US to run a wide current account deficit. But the low level of real interest rates fuelled an irresponsible expansion of credit and an unsustainable bubble in house prices. The Western financial system has been shaken to its foundations, with devastating effects on the real economy.

The Chinese economy cannot escape the collateral damage. Chinese export markets are diversified, but the US, Europe and Japan are all plunging into recession. China is growing at its weakest pace for five years, and industrial companies' profits are slowing sharply. The direct losses of Chinese banks from the collapse of the US sub-prime mortgage market have not been large, but they have contributed to a tightening of credit conditions in the domestic market. Exporters are finding it more difficult to obtain finance. Bad debts are increasing.

China is better placed to withstand the downturn than many other countries. But there will be a deceleration in growth and investment, and a risk of social unrest. Chinese policymakers should reflect on how best to avoid aggravating the weaknesses of the global economy. China's strategy of accumulating foreign exchange reserves through expansion of the trade surplus needs to be modified. China is a huge potential market for Western exporters. Its policymakers should now aim to stimulate domestic demand and implement structural reforms. These steps would help to stabilise the global economy, and could also provide the Chinese people with a better quality of life.