We are optimists by nature. Risks, however, are abundant. The US economy, as vibrant and diverse as it is, is affected by what happens in other parts of the globe. This month we look at China and try to assess what impact a severe economic slowdown there might have on the US economy.
China became the world’s second largest economy, surpassing Japan, in the second quarter of 2010. China’s historic 10% plus growth rates translated into high demand for raw materials, which affected global prices. Although GDP growth rates coming out of China are not reliable, it is generally acknowledged, even by the Chinese, that growth is slowing. Capital Economics estimates that China GDP growth will slow from 7.7% last year to 7.3% this year and 7.0% in 2015. In some quarters, there are well publicized fears of a real estate bubble and a looming credit crisis. What if our worst fears of an outright recession and a full blown financial crisis were to happen? What would be the effect on the US economy and financial markets?
China owns a lot of US Treasuries. Thomson-Reuters reports that China owns 11% of the outstanding stock, and at $1.3trn, is the largest holder of any foreign nation. Might China be forced into selling its dollar reserves to recapitalize its banks? In the early 2000’s, the banks were just given Treasuries. It was far simpler to do that than selling Treasuries and giving them cash. Outright sales would strengthen the renminbi, which would not be a likely policy objective. If capital were to flow out of the country, China might consider selling Treasuries to support the currency. However, extensive capital controls make that outcome unlikely. Ironically, the safe haven demand for Treasuries from around the world in the event of a Chinese recession might even lower yields.
A recession in China would reduce the demand for US products. While it would be very painful for any business that depends on exports to China, it would put only a small dent in the US economy. Total US exports are 13% of GDP, only 6.5% of which go to China. A hypothetical drop of 80% in US exports to China would mean less than a 1% drop in US GDP. Conversely, raw material prices would probably decline. If oil were to drop by 25%, there would be a positive effect on GDP.
One often stated concern about China is over the financial system. There has been a real estate boom and with it there are probably under reported bad debts. A severe financial crisis in China could well have adverse effects globally. Fortunately, the direct exposure of US banks to China is small. The Bank for International settlements (BIS) reports US banks’ holdings of Chinese government bonds, investment in Chinese banks and loans to Chines businesses or households is $83bn. That amounts to 6.4% of US banks’ Tier 1 capital and 0.8% of GDP. It is important to note that the US banking system is much better positioned to absorb financial losses. The Tier 1capital ratio is now at a record high 13.1%. Even if the US banks had to write off everything, the Tier 1 capital ratio would be well above the level when Lehman Brothers failed.
We do not wish to minimize the risks to a fragile US economic recovery, which is vulnerable to foreign shocks. We just do not think a slow-down, or even a recession, in China would cause major economic problems for the United States. “Black Swan” events are usually unexpected. China’s economic challenges are well-known and are being considered by market participants.
John Hess 
Falgun Jariwala 
Managing Principal Managing Director
jhess@nsinvestors.com fjariwala@nsinvestors.com
www.nsinvestors.com www.nsinvestors.com
- The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. They are those of the authors. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you consult your financial advisor.
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- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.