Up to now the dragon economy has remained relatively unscathed amid the Asian financial crisis, as if China was operating in a different hemisphere. This is due to soaring exports, a strong inflow of direct investment, record foreign exchange reserves and a record trade surplus.

Inflation, which led to the political turmoil of a decade ago, is close to zero. Gross domestic product grew at 8.7 per cent in 1987 and is likely to continue growing, though at a lower pace. In contrast to other currencies, the rate of the Chinese yuan remains unchanged at 8.3 to the US dollar, because it is non-convertible and shielded from speculators.

But China cannot remain detached from the deepening crisis sweeping Asia, and faces an uncertain economic future. There are concrete examples here and there of how the Asian meltdown is hitting the country.

Just like North America in the 1950s, China is engaged on a major road-building programme to modernise its infrastructure. In Shandong Province work began last year on five new highways and two bridges. Heavy machinery was moved in, and gangs of workmen began gouging out hills. The work has now stopped.

South Korea, which had underwritten four billion of the seven billion-yuan construction fund, pulled out because of its financial crisis.

As investment declines, a closer look at China's exports shows its strength is due not just to its competitiveness but to domestic weakness.

There is huge over-capacity and a glut of bloated inventories. A foreign businessman buying fishing gear told me recently he found his supply factory full of unsold fishing rods and accessories. The Chinese media has uncovered stockpiles of 1.5 billion men's shirts, 10 million watches, tons of cosmetics, 20 million bicycles, some 700,000 motorcycles and millions of yuan worth of unsold household items, according to John Anderson of the International Monetary Fund in Beijing.

In a paper delivered to an economic symposium in Hainan Province in November, Mr Anderson identified the twin issues of unemployment and enterprise bankruptcy as "perhaps the most controversial and worrisome for the Chinese authorities" as they could involve enormous claims on fiscal resources and could have repercussions on social stability and banking soundness.

China's banks are also in deep trouble. Officially 20 per cent of loans are "non-performing" and the real figure may be much higher. This is China's hidden financial crisis, according to central bank governor, Dai Xianglong. . . At a meeting of Chinese leaders in mid-November, Zhu Rongji, China's economic mastermind and next prime minister, declared that the practice of governors and mayors commanding bank directors must cease.

Most of the central bank's provincial branches which funnelled money to sinking State-owned enterprises are to be closed.

China biggest latent crisis is in the state sector, ridden with debtladen and grossly-inefficient enterprises from the Maoist era. Restructuring them is the biggest and most urgent economic challenge China faces. Beijing has decided to end state ownership and move towards government-backed conglomerates like in South Korea, along with some privatisation.

The Chinese State Council last year ruled that the biggest industrial concerns must encourage mergers, reduce the workforce and inefficiency and close down bankrupt enterprises. This was reinforced by a stern message from Zhu Rongji, who said: "This is the scripture and it should not be misread but followed!"

The plan carries the danger of labour unrest, guaranteeing that change will not come smoothly. Millions of Chinese workers are accustomed to the "iron rice bowl", a guaranteed job plus cradle-to-grave care. Thus, for example, the Maanshan Iron and Steel Co, China's sixth largest steel producer, owns 11 kindergartens, 15 primary and high schools employing 1,500 staff, a hospital with 900 beds and 1,200 staff, and 56,000 apartments.

Big enterprises like Maanshan are now laying off or not paying workers.

Statistical Bureau spokesman Ye Zhen said 12 million workers out of a 120-million strong urban workforce were laid off last year and only half had found new jobs. The real figure could well be 30 million, western economists say.

For the first time Chinese newspapers are openly forecasting big redundancies, preparing the population for a major shift in work patterns.

More than one million workers will be laid off by the Ministry of Railways in the next two years as it eases its monopoly of rail transport. On a tour of southern provinces in December, Zhu Rongji, sounding more like a Wall Street financier than a Communist ideologue, declared: "Over-staffing is a common problem in state-owned enterprises. There is no way of making them a success without down-sizing."

The Asian turbulence will make this crucial reform harder. It has hit hard the Hong Kong stock market which Beijing hopes will raise the required capital. The Hang Seng Index fell in six months from 1,600 to below 1,000 and high interest rates in Hong Kong are hurting lending banks.

China needs a fast growth rate to restructure its state sector and absorb the tens of millions of surplus workers. But the first statistics of the new year are not encouraging. They show a lacklustre final quarter for 1997 and the slowest growth for six years, though still impressive at 8.8 per cent. Foreign investment, which reached $44 billion last year, is now expected to drop sharply in 1998.

The fall in Asian currencies by up to more than 70 per cent of their value against the US dollar increases China's problems in competing for export markets, though it means cheaper imports for many of the materials and parts which China assembles for re-export.

There is considerable pressure on Beijing to devalue the yuan but Zhu Rongji has ruled this out. It would put enormous pressure on the Hong Kong dollar's peg to the US dollar, as half of Hong Kong's GDP is linked to China. If it went, the value of Hong Kong's stock market for raising capital would fall and confidence in the region could evaporate.

To avoid devaluation, however, China will have to cut costs to encourage exports and find ways to attract new investments at a time when investors think that devaluation might come through gradual slippage. The one-year forward rate of the yuan is already 9.6 to $1 as against $8.3 now.

There are compelling political reasons for not having a sharp devaluation in China. It would cause Asian economies to dive further and the knock-on effect on international markets would be much more dangerous than in recent months. Some analysts think Washington is likely to reward Beijing's perseverance by removing its obstructions to China joining the World Trade Organisation this year.

The Asian crisis is also creating new strains between China and Taiwan which it regards it as a renegade province. Taiwan has remained economically strong and Beijing fears it will use financial assistance to the region to extract diplomatic gains.

As always the question "What to do?" is accompanied by "Who's to blame?"

Critics say China set the stage for the crisis with its steep currency devaluation in 1994, when an estimated 33 per cent drop in the value of the yuan gave a huge boost to Chinese exports to the west at the expense of Thailand, Malaysia and Indonesia. The official People's Daily retorted that the devaluation, when it aligned its official rate of exchange with the market-driven rate, was only 7 per cent.

China for its part this week accused the United States as do many political leaders in the region of promoting the US political and economic model by imposing harsh terms on financial aid to troubled Asian nations. For now it offers no alternative but the longer the crisis goes on, the more likely that new strains will appear in relations between China and the US, which had been on the mend throughout 1997.