China is not Las Vegas.
Las Vegas is well known for its tagline “What happens in Vegas, stays in Vegas.” And while that may be true for Sin City, the same logic does not necessarily apply to all exciting and exotic destinations. Case in point is China which rarely goes unnoticed anymore because it is big, actually HUGE! In some ways the Middle Kingdom has always been big; it is the 3rd largest country by land mass (behind Russia and Canada) and the largest in the world by population. At 1.4 billion, nearly one out of every five people on the planet live in China!
Economically though, China’s size is a relatively new phenomenon as it has grown from the 11th largest economy in 1980 to the 2nd biggest economy in the world today. Size matters and as a result trends in China affect the lives of Americans by influencing prices for things we buy, wages earned at our jobs, and even the value of our investment portfolios. In our interconnected world, China cannot be Vegas. What happens in China is now often felt far beyond its borders.
What’s going on?
China’s GDP growth averaged 10% per year for nearly two decades. This incredible pace of growth was based upon productive investment, an ample labor force, relatively low wages and a parabolic rise in exports. Now, China’s growth has recently moderated to 6 -7% per year and the country must carefully make the necessary shift away from an export and investment led economy to a more consumption and service driven economy like the U.S.
This transition is necessary so China can reduce its dependency on the state of the global economy and foreign demand for its products. Weakness in the country’s export led economic model was apparent when international trade suffered a sudden collapse during the financial crisis. Policy makers in China had to respond to the precipitous drop in exports by providing a massive stimulus package to prop up the economy. Going forward the country needs to encourage its consumer base with greater purchasing power. Doing so should help sustain the country’s growth (albeit at a slower rate) over the next decade and beyond.
The core issue is whether China can successfully make this economic transition and how much disruption it causes to the rest of the world along the way.
The year of the Monkey…
In the Chinese zodiac, 2016 is the year of the Monkey – a period often characterized as volatile and unpredictable. This may be a bad omen for markets, but China’s transition will be unfolding far beyond this year. Furthermore, history teaches us that transitions can turn out well, but are rarely ever smooth.
China’s ripple effects can impact growth, inflation and policy rates in other countries through many different channels. Here are a few:
- Countries with close ties to China (Japan and emerging Asian countries) can be impacted by lower demand from China.
- A depreciating Yuan can increase demand for cheaper Chinese exports, driving down import prices for other countries and thus lowering inflation. This is the opposite effect of what many Central Banks are trying to accomplish at this time.
- A tightening of financial conditions in China could spill over into other countries reducing consumption and investment demand.
The list of concerns and financial linkages are legitimate, but Chinese policy makers are supporting the economy through this economic transition. Their ability to balance between growth and reform objectives will be imperative.
While the potential for significant spillover effects is there, it is important to remember that China is still segregated from the world economy in several key ways. The country continues to impose capital controls and limits on security purchases by foreigners, and has a highly restrictive banking system that is predominantly state owned.
News from China will likely continue to contribute to market volatility, but remember, successful investment strategies are not built upon current market conditions. Instead, focus on your specific goals and constraints and develop a portfolio based on reasonable forward looking expectations for return and risk.
Brandy Niclai, CFA®