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Investor Discussions - Understanding China

| November 13, 2015
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Investment

China: Economic Friend or Foe?

Over the last few years, the outlook of the Chinese economy has become a hotly debated topic. Many experts suggest the Chinese economy is stalling and a hard landing is imminent. Others feel the slowdown is temporary and growth is just around the corner. In this piece, we’ll discuss the current state of the Chinese economy and the implications for the U.S. economy.

The World's Second Largest Economy

According to the World Bank, China currently ranks as the globe’s second largest economy, trailing only the U.S. With a population of over 1.35 billion people, labor participants and consumers are not in short supply. This has allowed their economy to expand at a nearly double-digit average annual growth rate since the early 1990s when the country underwent significant economic reform.

In fact, the amount of goods the Chinese consume as a percentage of the global consumption is nothing short of amazing. As of 2014, the Chinese consumed 50% of global copper, 48% of global aluminum, and 12% of global crude oil. The Chinese also continue to import large amounts of consumer goods such as electronics. Apple reported during its Q3 2015 earnings call that its revenue from Greater China was up 99% year-over-year and totaled nearly 25% of its total sales. It’s clear that even if China is slowing, it remains a global growth engine.

Change is on the Way

Over the last few years, the Chinese government has attempted to transform its economy into a service-based consumption model and away from its historical role as an exporter of manufactured goods. In addition, they have tried to reign in the country’s growth rate. The leaders recognized that the double-digit growth experienced during the prior decades was not sustainable over the long term.

During the financial crisis of 2008 and the recession that followed, the Chinese saw how reliant they were on global demand linked to manufacturing and decided a change was needed. From there, Chinese leaders focused on growing their services sector which includes areas such as finance, education, and healthcare. As of Q3 2013, the Chinese services sector surpassed the manufacturing sector for the first time since the early 1990s (Chart 1). This is a trend that many analysts expect to continue into the foreseeable future.

Cracks in the Façade

Overall, it appears the Chinese plan to become a global service-based consumer is on track. However, it hasn’t come without problems and many underlying issues exist. For instance, real estate bubbles, stock market booms and busts, and an over-levered shadow banking system have created many headwinds for the economy. This has caused significant amounts of capital to leave the country and has negatively impacted GDP. In addition, credit demand and total imports have slowed, indicating that both businesses and consumers are feeling the pinch. Lastly, the U.S. dollar has strengthened significantly over the last year and put pressure on their exports (their currency has a loose peg to the U.S. dollar).

One silver-lining for China is the large amount of foreign reserves the Chinese central bank, the Peoples Bank of China (PBOC), has at their disposal (Chart 2). It’s clear that the PBOC has significant dry-powder on hand to help stimulate their economy and they are not afraid to use it. The PBOC continues to utilize many forms of direct stimulus in hopes of increasing growth and instilling confidence in their economy. Examples include: infrastructure projects, rate cuts, and direct intervention into their capital markets. All of this has helped to stabilize their economy but they face an uphill battle from here.

Impact on the United States

Generally speaking, the U.S. is well insulated from the Chinese economy. Less than 8.0% of S&P 500 index companies derive their revenues from Asia, and China makes up an even smaller percentage of that amount. However, as the global economy continues to become more interconnected, it’s likely that a hard-landing in China would have some sort of spillover effect on the U.S. economy

The global equity market selloff in August of this year is a great example. In early August, the PBOC allowed their currency to devalue against the U.S. dollar in hopes of stimulating economic growth (this should theoretically make their goods cheaper and thus stimulate demand). This move startled experts as they suddenly became concerned that China’s economic situation may be worse than expected. From there, the global markets went into a tailspin and the U.S. stock markets corrected over 10%. Since then, China’s economic data has stabilized and fears have largely subsided, but it highlights a great example of how connected our economies and capital markets are today.

Conclusion

China has gradually become one of the most talked about financial topics over the last few years. Experts continue to disagree on China’s economic outlook and whether or not they can effectively transform the economy into a service-based consumption model. Even so, China remains the world’s second largest economy and has a massive war chest of reserves to help stimulate growth. In addition, the negative headlines are likely overdone at this point. With over one billion citizens ready to work and consume goods, it’s unlikely that China is going away anytime soon.

As always, please feel free to contact us with any questions you may have.

 

William Kring, CFP®, AIF®
Chief Investment Officer

Matt B. Bailey, CFA®, CMT®
Portfolio Manager


Source: World Bank, Leuthold Group, JP Morgan, Wall Street Journal, PIMCO, Fidelity Investments, St. Louis Federal Reserve

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