Why Should You Be Worried About China?

International economists use the term “global growth engine” – those large economies whose ample imports, exports, and investment flows stimulate economic activity among their trading partners. Nineteenth Century Great Britain was the growth empire. British capital built much of the U.S. railroad systems as its factories consumed American cotton and its consumers ate American food. In the Twentieth Century, the U.S. became the global growth engine, eventually being joined by the collective power of a recovered Western Europe. In the Twenty First Century, China has become a global growth engine. It is the largest manufacturer in the world and may eventually pass the U.S. as the largest economy.

Here’s how China affects the U.S. economy:

1. Commodities: Although American’s think of China as a manufacturer of exported consumer goods, the bulk of its output is heavy goods, pointed toward domestic infrastructure. That makes China the world’s dominant consumer of basic commodities like lumber, steel, scrap, and concrete. China is also the world’s second largest importer of coal and third largest importer of oil. Finally, China is a major importer of food and fertilizer. As China has fueled the recent boom in commodity production, a reduction in demand would cause a global commodity bust.
2. Debt: China is the largest holder of U.S. debt. Its purchases of debt instruments strongly affect U.S. interest rates.
3. U.S. Imports: As our dominant supplier of consumer imports, Chinese labor and production costs have an affect on U.S. inflation rates. Those same import flows have had a strong negative effect on U.S. manufacturing growth.
4. Value of the Dollar: The Chinese currency, the RMB, is challenging the Dollar’s position as the world’s principal trading currency. Historically, the Chinese have held the RMB’s value down, compared to the Dollar, to boost exports. Nonetheless, the RMB has slowly appreciated against the Dollar. As it gains in influence, it will appreciate more. Although, in the long run, a falling Dollar will help U.S. exports; in the short run, its fall would fuel U.S. inflation and raise interest rates.

Downside Risks
Here’s why these powerful effects are a major downside risk over the next five years. China has been on a thirty-year run of uninterrupted economic growth, averaging over 10%. Not only has this growth boosted China’s influence, but its steadiness has made many markets dependent on that growth.

Two factors argue that this growth will soon stop. First, China’s economy is more than 60% driven by investment and manufacturing activity. Those are the sectors most vulnerable to recession. China is now the economy most inherently vulnerable to recession. Bubbles in housing and infrastructure markets suggest that it will happen soon.

Second, the Chinese economy is a government “managed economy.” Managed economies work best for building heavy public and manufacturing infrastructure. As it matures, the Chinese economy needs to become a consumption economy. Managed economies do that badly. Bureaucratic tastes are poor substitutes for consumer tastes. Chinese growth rates will fall dramatically as it struggles with this transformation.

Worst Case Scenario
Here’s a worst case scenario that illustrates the U.S. risk of a Chinese recession. The end of the capital building boom dries up Chinese commodity imports, kicking off recession in U.S. commodity markets. The need for Chinese domestic stimulus causes a major withdrawal of Chinese capital from U.S. debt markets, raising interest rates. Chinese exports attempt to cure their problems by dumping product on the U.S. market—ensuring a mini trade war. U.S. recession causes the dollar to fall, raising the price of imported oil.

Summary
Lest you think that this worst case scenario is unlikely, consider the U.S. housing forecasts of 2006. Fortunately, the Chinese have ample currency reserves to stimulate their economy now. By mid-decade, however, the negative pressures will be strong enough to make recession possible. That is about the time when the U.S. will be due for a downturn anyway. It follows that you need to make your mid-term business plans with caution. In the meantime, keep a close eye on reports about the Chinese economy. The latest news is a reduction in growth forecasts—albeit to 8% – but a reduction nonetheless.