Slowdown in China Will Be Another Drag on U.S.

There's no danger of a recession in China, but growth will slow -- and that's bad news for America.

By Andrew C. Schneider, Associate Editor, The Kiplinger Letter

February 9, 2009

China's slump will add to America's economic pain. The Chinese economy will grow by 6.5% in 2009. That's far better than any other major economy will do this year, but it's a sharp comedown from last year's 9% expansion. China is staggering under the near simultaneous collapse of overseas demand for its exports and of its domestic property market. Large numbers of factories are shutting their doors, and those that remain are scaling back orders.

U.S. exporters are already being slammed. Semiconductors and manufacturing equipment for producing them are among the worst hit so far. The IT components, heavy machinery, plastics, chemicals, construction equipment, iron, steel and aluminum industries will all see orders fall in coming months. And Chinese airlines will postpone delivery of planes, or even cancel orders, as demand for travel drops.

The impact on U.S. trade will be massive. China is America's third largest foreign market, taking roughly 6% of U.S. goods exports worth about $68 billion last year. Add to this decline a drop in sales by U.S. affiliates in China -- not to mention demand for services, such as banking and finance -- and the toll on U.S. firms is even greater. Plus China's weaker demand for raw materials and intermediate goods will magnify the problem. Japan, South Korea, Taiwan, Singapore, Brazil, Australia and Chile will all suffer from China's slower growth. Collectively, these seven countries absorb 17% of the goods exported from the U.S.

Then there's the question of China's effect on U.S. financial markets. For years, Beijing has helped to hold down U.S. interest rates by taking dollars spent on Chinese exports and investing them in U.S. bonds -- mainly government instruments, such as Treasuries and agency bonds, but some corporate debt as well. As China's exports decline, it will have fewer dollars to recycle. Inevitably, that will push U.S. interest rates up.

But there's no chance of a mass withdrawal of China's capital. China is by far the U.S.' biggest foreign creditor, with assets of somewhere between $1.3 trillion and $1.7 trillion, equivalent to 30%-40% of China's GDP. Andy Rothman, a China strategist with investment firm CLSA Asia-Pacific Markets explains, "If they were to try to dramatically reduce their holdings in U.S. securities, it would spark a sell off that would hurt them more than anyone else." Bluntly put, it would be the economic equivalent of a murder-suicide.

Though China's growth rate will slow, its economy won't shrivel. The Asian giant has plenty of tools to fight its slowdown, including fiscal stimulus. Chinese debt -- at the government, corporate and household levels -- is minimal, so there's plenty of room for China to spend more without driving up interest rates. Beijing is ramping up investments not only in infrastructure projects to provide jobs, but also in health care, education, pensions and transfer payments to households. The aim is to stimulate consumer spending. With a better social safety net in place, ordinary Chinese will be more willing to make use of their savings. For the same reason, the government is subsidizing a wide range of consumer goods, mainly large household appliances, but also cell phones, color TVs, computers and even cars and motorcycles.

Beijing is also forcing banks to lend more. Because it owns China's financial institutions, it needn't rely on persuasion or incentives to get its way, as Washington must do with U.S. banks. And China has lifted many of the recent barriers to real estate acquisitions. Imposed to deflate China's property bubble, the restrictions wound up bursting it.

Such efforts will shorten China's downturn, but they won't be enough to prevent it. When the recovery arrives, expect its GDP to settle back into an annual growth rate of 8%-9%. That will provide a shot in the arm for the global economy and U.S. business, though not as much as China's double-digit rate of expansion from 2003 through mid-2008.

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