Yahoo Finance 3 Reasons Why China Still Matters
China has hogged the headlines for the last few years and it's no surprise why. Its economy is massive and (supposedly) growing at more than 6.5 percent annually. The country is the top consumer of many natural resources and a main driver of global growth.
So, when the Chinese economy is giving signs of a slowdown, the effects can be far reaching and impact investor psyche. Given the current market environment we wanted to highlight three main reasons we believe China will continue to be a flashpoint in the markets for the foreseeable future.
[See: Chinese ETFs: 9 Ways to Play the Middle Kingdom.]
It's an economic powerhouse. Despite the possibility of a slowdown, China is still an economic force to be reckoned with. Besides the U.S., no other country comes close to matching the GDP of China. In fact, China's GDP is greater than Japan, Germany, France and the U.K. combined. The country is also a major importer of natural resources such as oil, copper and iron ore. The economic growth over the last few decades has helped boost demand for resources such as these, thereby propping up other emerging markets economies and resource exporting countries. Nearly 23 percent of all Chinese imports come from resource-rich countries like Africa, Australia, the Middle East and South America. To add some perspective, China consumes over 10 billion barrels of crude oil each year on average. That's more than double its nearest competitor, Japan, while only the U.S. consumes more.
China's large appetite for natural resources is only part of the overall demand picture for the country. Over a 12-year period from 2001 to 2013, China's imports of merchandise for its expanding middle class grew more than eight fold. Indeed, China's middle class is expected to grow to 40 percent of its total population by this year. That's roughly 370 million people with more disposable income and demand for retail goods and services, creating a huge opportunity for multi-national companies and retailers in the Chinese markets.
Despite the explosive growth, there will be periods where it slows or even contracts. As the world economy becomes more globalized, ripples in one country can be felt across borders. As we pointed out above, China is a major driver of global growth. According to the International Monetary Fund, a 1 percent slowdown in China's economy translates into an estimated 0.3 percent slowdown in other Asian countries. While this only takes into account China's impact on the Asia-Pacific region, we would point out the contagion could spread to other countries that rely on its consumption of natural resources and imports.
The strength of the yuan drives the price for imports. China's currency, the yuan, has been the center of attention this year. China's central bank, the People's Bank of China, attempted to devalue the currency slowly to stimulate more growth and remain competitive. It does this by setting the exchange rate for the currency every morning and allowing it to fluctuate in a narrow band around that daily starting point.
However, during the first week of the year, the central bank devalued the yuan by the largest amount since last August, implying a weaker economy than the government had previously announced. This sparked an even further devaluation in the currency by investors as they attempted to sell Chinese assets and exchange the yuan for other currencies. The broader markets reacted negatively, kicking off what was the worst first week for U.S. investors in history and pulling global markets into the red for the first part of 2016.
The yuan is important to investors for a number of reasons. As the Chinese economy begins to transition from an export-driven to a consumption-based economy, a lower yuan means higher-priced imports for the Chinese. This adds to the deflationary pressures that already felt exacerbated by oil and could potentially cause additional slowing of consumer spending and, ultimately, economic growth. We recognize that the bulk of China's current growth stems from export-oriented activities. The combination of reduced imports due to a cheaper yuan and fewer exports if global growth slows has many investors worried.
In response to China's currency manipulation, other emerging markets countries may look to devalue their currency as well. The fear is that these countries will create additional market stress in an attempt to make their currencies cheap relative to the yuan. It's easy to see why they may devalue their currency; many emerging markets countries export natural resources and China is one of their largest customers.
So, if China's currency is devalued, these countries end up getting less in their own currency once everything is exchanged. Also, many of these countries issue debt in U.S. dollars and, if they devalue their currencies stay competitive with China, their debt burdens become even greater as they struggle to exchange their devalued currency for an even higher U.S. dollar.
[See: 13 Stocks to Buy to Bet on China.]
The economy remains centrally planned. One thing many investors can lose sight of is the fact that China is still very much a centrally planned economy. The Chinese government calls the economy a "socialist market economy." It can be argued that they have made progress towards opening up their markets and enacting capitalistic measures, but data coming out of China has been suspect for some time now. Indeed, many investment firms perform their own economic analysis on China since there has been a documented history of less-than-accurate economic statistics provided by China's government.
Many investors still remember the Asian financial crisis where China claimed a 7 percent growth rate while many other Asian countries were in recessions.
China's banking system is dominated by state-owned banks that receive direct and indirect guidance from the government. These banks have lending volume caps imposed by the People's Bank of China and are discouraged from lending to various industries. Because credit has been hard to come by for large swaths of the Chinese markets, borrowers have instead turned to shadow banking to get their loans.
Shadow banking is where institutions not officially governed by the banking industry offer loans to people. In many cases, a legitimate bank may be at the heart of the loan but it is originated with an unregulated institution so as to avoid governmental regulations and costs. While these loans may help spur economic growth as small businesses and individuals not generally served by China's banking industry are able to get credit, they do contribute to financial instability.
Because of the lack of governmental oversight and looser credit standards, these loans are typically riskier than those regulated by the People's Bank of China. According to a report in 2015, an estimated two-thirds of shadow banking loans are directly tied back to regulated banks. This contributes to the issue of data clarity surrounding Chinese markets. If a bank's balance sheet paints a rosier picture than its true condition when taking the off-balance sheet loans into account, that bank's stock may be wildly overvalued. Also, there is no ability for investors to look at the credit quality of those loans. Are they high quality or low quality? Investors just do not know. China has been cracking down on this recently in an attempt to clean up its credit markets by requiring banks to report these loans on their balance sheets but there is still progress to be made.
The currency is another example of the distorting impact of the nation's "socialist market economy." The Chinese central bank has been heavily involved in manipulating the yuan's currency market. More recently, China's central bank has begun to implement controls designed to stem the flow of money leaving China and the yuan. These controls make it more difficult for foreign companies in China to repatriate their earnings, lower amounts of Yuan available to banks in Hong Kong to lend and preventing Yuan-based funds from making foreign investments.
China's direct involvement in manipulating its currency and economy ultimately prevents investors' expectations from being fully reflected in the markets, creating uncertainty and volatility in the process.
[See: 10 Ways to Play in the Asia-Pacific Stocks Pool.]
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. The economic forecasts set forth in the presentation may not develop as predicted. International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
Brett Carson, chartered financial analyst, is the director of research for Carson Institutional Alliance where, as portfolio manager, he is directly responsible for managing several investment strategies, including Perennial Growth, LongTerm Trend and Write Income.
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