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Fixed-Income Insights

Here's a look at how slowing growth in China could affect economies elsewhere.

 

In Brief

  • China, which has accounted for a large share of global economic growth in the past decade, may be on the brink of a significant economic slowdown.
  • Investors are concerned that economic and market volatility in China could affect economies worldwide.
  • How might this play out? Economies closely tied with China could suffer the most, while less export-dependent nations, such as the United States, may fare better.
  • The key takeaway—While China takes steps to forestall a significant slowdown, the global consequences of its actions could be significant—and should be a prudent consideration of security analysis as well as asset allocation.

 



 

China matters. During the current decade, the nation has accounted for one-third of the global economy’s expansion, compared with 17% from the United States, according to Ruchir Sharma, head of emerging markets at Morgan Stanley Investment Management. Bloomberg View reported that by the end of 2014, China accounted for at least 38% of global growth. Unfortunately, we may be about to experience the downside to China’s emergence as a force in global growth.

The problem, of course, is the prospect of a significant slowing in the Chinese economy. While many investors perceive a global economic slowdown only in the context of U.S. economic weakness, the numbers cited above suggest that a serious economic problem in China could kick-start a global recession, potentially choking off U.S. growth in the process. 

What’s behind these worries? The recent boom and bust in China’s property prices, followed by a similar trajectory for equity prices, suggests China may be predisposed toward the type of financial volatility that is capable of wreaking havoc on economies elsewhere. An economic slowdown in China could substantially reduce demand for everything from cars and luxury goods to iron ore and crude oil. For example, Japan, which counts China as its largest export market, could move quickly from growth to contraction. Countries such as Singapore and Korea, whose exports to China alone account for 17% and 10% of their GDP, respectively, according to financial information provider Trading Economics, could be devastated.

Investors were reminded of the potential consequences when China moved to devalue its currency, the yuan, on August 11. Valuations of equities, currencies, and debt around the world experienced the impact immediately. China’s August foray into yuan devaluation clearly demonstrated the potential global impact of its economic policies as well as the level of global concern regarding the true nature of China’s growth.

A Big Debt Burden
Most concerning about China, though, is its debt. At nearly 300% of GDP, according to McKinsey, China has a greater debt load than the United States, Germany, or Australia. What’s truly eye-opening is the rate at which the debt has grown: McKinsey reported that debt quadrupled, from $7 trillion in 2007 to $28 trillion by mid-2014. Much of that is corporate debt, often issued to support property development and infrastructure projects with questionable economic fundamentals. A slowing Chinese economy could trigger defaults, especially if the pressure to demonstrate economic growth in recent years had compromised proper due diligence of the projects that were financed. The situation seems eerily similar to ambitious mortgage lending in the United States, which resulted in the 2008–09 financial crisis that spread globally. It would not be surprising, then, to discover that China’s worsening economic health, and its potential to foster a global downturn, is the chief worry keeping investors awake at night.

As devastating as a global recession would be, all investments will not suffer alike. U.S. investments, for instance, may fare better than many other global alternatives. With only 13% of U.S. GDP driven by exports, according to data from the International Monetary Fund, there may be some insulation from a global slowdown in a U.S. economy driven largely by internal consumption. Furthermore, a global downturn initiated outside the United States could result in a “flight to quality” to select U.S. assets, with highly rated short-term debt likely to benefit. Other asset classes, including U.S. equities and corporate debt, also may perform well relative to global counterparts, depending on how well U.S. growth holds up, and the dependency of a company’s earnings on domestic economic exposure. 

It is difficult, though, to predict investment flows in such a situation. There are no precedents to analyze. It seems safe, however, to conclude that a serious economic problem in China is likely to be a serious problem for the world.

Avoiding the Worst
And yet a serious problem may not unfold. The controlling nature of the Chinese government, combined with the economic resources at its disposal, suggests that an overly negative outcome may be avoided. We have seen Beijing succeed at reviving the nation’s declining property market and reversing an equity market downdraft, though weakness in major indexes has reemerged. Beijing may succeed in managing a tolerable economic slowdown as well.

However, even a modest economic slowdown in China could still have important consequences. Cooling activity over the past six to nine months has reduced demand for numerous commodities, adversely affecting mining activities in Australia as well as commodity-exporting emerging markets, such as Brazil and Chile. Further softness in China could broaden, as well as deepen, the potential spillover effect on emerging economies. The broader economic effect would come from reduced demand in China as well as from Chinese policy responses to improve domestic and export competitiveness, including devaluation of the yuan. Other Asian economies, for example, could be hurt by the reduced demand from slowing Chinese growth, and by the increased competitiveness of Chinese exporters benefiting from a weaker currency. 

In addition to emerging markets, specific companies in other economies also could be affected if China’s slowdown continues or, worse, accelerates. A number of developments gleaned from corporate earnings reports bear this out. During the first half of 2015, for example, apparel company Burberry reported a decline in China sales, compared with an 11% increase for the same period in 2014. Automakers also ran into difficulties. During the first half of 2015, Toyota’s exports to China declined 50% year over year, while BMW warned of a 40% drop in profitability in the country. Equipment firms suffered as well: United Technologies cited weakness in the Chinese market to explain lower earnings, while Hitachi and Komatsu expressed concern over a sharp decline in excavator sales.    

Pockets of Strength
Opportunities still remain, however. Not all emerging markets are dependent on China as a key market. And many global companies continue to thrive, even within China. Pharmaceutical maker Merck & Co. and radiation-oncology firm Varian Medical Systems both cited business as being “brisk,” according to a Wall Street Journal article (August 17). Other major U.S. companies with global reach have also cited noteworthy sales growth in China. Outside China, exporters in Europe that benefit from a substantial euro devaluation over the past year might prove attractive to investors. The debt and equities of U.S. companies focused largely on consumer-driven domestic growth also may have appeal. 

China has provided important support to global economic growth since the 2008–09 financial crisis, creating numerous investment opportunities in the process. Recent volatility in China’s property prices and equity markets, combined with the likelihood that much of the nation’s growth may have been financed with a drastic increase in debt, seem to herald a slowdown of some degree. As China manages this apparent economic transition, the global consequences of its actions could be significant, and should be a prudent consideration of security analysis as well as asset allocation.

 

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