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The China Bogeyman

I grew to dislike the TV show “Scandal.” The histrionics, the vapid phrases beaten to death, and the core cast of comic-book characters designed to keep viewers constantly off guard.

For many of the same reasons, I can’t stand the current stock market. Emotions send it down 400 points one day and up 250 points the next. Pundits who don’t know why the market is down call it “profit taking”; those who don’t know why it’s up call it “bargain hunting.”

The core cast includes: Interest rates, dropping oil prices and of course, China. If China were a character in “Scandal,” it would be Rowan Pope, the powerful, shadowy, unpredictable, destructive father of the heroine. Just what Pope is responsible for, and what he’s capable of, is always in doubt.

China plays the same role now in international finance. How much of its economy is based on loans (government loans? bank loans? who can tell the difference?) that can never be paid back? With little transparency, which enterprises can you trust? What is China capable of when it comes to devaluing its currency and cleaning up its ambiguous market system?

China has been portrayed by analysts in recent weeks as either the tail that wags the U.S. dog or the largely irrelevant flea on that dog’s back. We’ll never be able to pin down Pope’s character, the “Scandal” writers will see to that, but we can pin down China’s influence on the United States and remove its bogeyman status.

Three Influences

When it comes to trade, China doesn’t have a great influence on America, though it is a major trading partner. How can that be? As you can see in the table, while the U.S. is a roughly equal trading partner with Canada—our single-country biggest partner—we import about four times as much from China as we export to it.

MOM United States Trade 2014 (4)

That insulates us to a large degree from harm via trade, and those numbers have caused some analysts to say a flagging China won’t have a big effect on the U.S. economy. China is desperate to keep its export-based economy humming, so it is devaluing its currency to keep its products cheap. Cheaper Chinese products are good for U.S. consumers (shoes, toys, furniture—more than half the stuff sold in Walmart comes from China) and businesses (machinery).

And given the U.S. exports relatively little to China, a weaker China won’t have a major impact on our economy. But it will have some, especially as our economy isn’t that robust, so we rate a weaker China as a moderate negative to U.S. exports.

The European Union will also be hurt by fewer exports to China. Because the EU is our major trading partner and its economy is just starting to recover, that doesn’t bode well for us, but that’s an indirect effect.

When it comes to U.S. debt, China’s threat to our economy is non-existent.

China has been selling lots of U.S. Treasury bonds to raise money to prop up its economy as its apparent credit bubble deflates. Bloomberg recently reported that China cut its bond holdings $187 billion in the first 10 months of last year.

As a major U.S. debt holder, with $1.2 trillion of our federal debt, China is second only to Japan. China was key in hoovering up our bonds after the financial crisis to help us finance massive deficits.

In theory, China selling our bonds could depress our bond prices and require the Federal Reserve to pay higher interest rates to keep our bonds attractive so it can continue selling them. Politicians, particularly, used to warn that China could crash our financial system by dumping our bonds.

But here’s the ironic thing: China’s troubles are scaring investors the world over, making the safe haven of U.S. bonds even more attractive. That increased demand is actually driving down Treasury bond interest rates. So China selling our bonds—or even dumping them wholesale—is a non-factor.

Finally, could China cause global deflation that would turn around and bite us? Deflation is a vicious problem that can crash economies. When prices fall, buyers will wait to buy things that are cheaper in the future, and spending is the lifeblood of an economy. Delayed spending cuts demand, causing producers to cut prices further to sell more. Pretty soon businesses close, workers lose wages or have to accept lower wages to survive—it’s an economic death spiral that’s hard to reverse.

China is essentially exporting deflation right now. The prices of goods China shipped to the U.S. fell by 1.7% last year, for example. By dropping the value of the yuan, China is exporting deflation around the world, too. And other countries that compete with Chinese exports have to drop their currencies to stay competitive. South Korea, Thailand and Malaysia, for example, have all followed suit.

Also, as China tries to shift from a manufacturing to a more consumer-oriented economy, it has cut purchases of raw materials the world over, driving them down in price. You can’t hang the drop in oil prices on China, but cheaper oil also contributes to deflationary fears. However, China is the world’s largest importer of oil; if the country’s demand for oil declines significantly, that could drop oil’s price further. But so far the world’s demand for oil continues to grow.

Central banks the world over have tools to combat deflation, so it’s not the problem it once was. The last big case was during the Great Depression, though deflation was a scourge that periodically swept the U.S. economy of the 19th century.

How bad can the China-exporting-deflation threat be? Today, perma-bear Albert Edwards, strategist at the bank Société Générale, predicted that global deflation sparked by China will wipe out 75% of the S&P 500’s value. Edwards was quoted recently in The Economist as saying, “Emerging market currencies are still in freefall. The U.S. corporate sector is being crushed by the appreciation of the dollar.”

Given that China is the world’s largest exporter ($2.34 trillion in 2014, versus $2.17 trillion for the EU and $1.63 trillion for the U.S.), every time China drops the value of the yuan the threat of deflation rises. That threat is as powerful as actual deflation, because just the perception that deflation is about to happen can cause a deflationary spiral to start.

This is why when China’s stock market drops, the repercussions are relatively minimal for the rest of the world’s markets, but when China devalues, markets here and elsewhere are rocked.

Fortunately, several mitigating factors counter the China-deflation narrative. Globally, production is picking up—at least among developed countries. The World Bank predicts that while global growth slowed to 2.4% last year, it should reach 2.9% this year, “as a modest recovery in advanced economies stabilizes major commodity exporters.” You can’t have deflation when economies are expanding.

Plus, the decrease in inflation rates among the world’s top economies seems to be slowing and even reversing in some cases, so we are no longer inching toward deflation territory.

Yes, the World Bank has been wrong before, but not as consistently as doomsayers such as Albert Edwards.

China is a mess and an unknown, no question. It’s the Rowan Pope in our scandalously uncertain financial drama right now. But our cast of characters includes expanding economies and tough central banks that should prevent a Chinese collapse from dragging down the rest of the world’s markets.

 


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Stock Talk

William Popp

William Popp

Outstanding analysis — this is the kind of work I can take to the bank. I almost didn’t open this fearing I would have to put up with a series of ads.

Thank you.

Alan Mansfield

Alan Mansfield

Superb analysis. The market reactions definitely make more sense now. Keep up the good work.

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