China's economy: It's worse than you think


[video]http://finance.yahoo.com/video/chinas-slowdown-stretched-beyond-borders-134223063.html[/video]

Knowing China's economy is slowing is like knowing you can save 15% or more on car insurance with GEICO. Everybody knows that.

But fewer people are focused on the magnitude of China's slowdown, much less considered the potential far-reaching implications for U.S. policymakers, investors and consumers.

Data released this week for the January-February timeframe have raised alarm bells among China watchers. Notably:

-- A 6.8% year-over-year growth in industrial production is "the weakest year-over-year reading ever (China’s IP data starts from 1995) outside the global financial crisis," according to Goldman Sachs.
-- Year-over-year retail sales growth of 10.7% is the lowest in over 9 years, according to IHS.
-- A 13.9% year-over-year increase in fixed-assets investment is the lowest in 14 years, according to IHS.
-- The Producer Price Index fell 4.8% vs. the prior year, the steepest drop since 2009.
-- Electrical consumption rose just 1.9% year-over-year after climbing 3.2% in 2014, the weakest in 16 years.



JPMorgan and Barclays each cut GDP estimates for China in reaction to the latest numbers while Goldman Sachs predicts the "exceptionally soft data" will prompt the government to "loosen policy further."

The People's Bank of China (PBOC) has already cut its benchmark interest rates twice in the past three months and cut reserve requirements for lenders in February. In response, M2 money supply rose 12.5% in February vs. a year ago, the highest in 4 months and aggregate loans were 1.35 trillion yuan, well above the consensus estimate of 1 trillion yuan.

In addition, PBOC Governor Zhou Xiaochuan on Thursday said the central bank may lift the cap on rates banks can pay depositors, which should increase competition in the sector. And on Wednesday, China announced plans to restructure its more-than 100,000 state-owned enterprises although the plan calls for combining enterprises vs. large-scale privatization, The WSJ reports, disappointing hopes for a more market-based approach.

As grim as the numbers are, it's too soon to declare 2015 will be the year of the proverbial hard landing in China, says Cardiff Garcia, U.S. editor of FT Alphaville. "The Chinese government still has an awful lot of firepower it can throw at this."

Scale of the Response

How this ultimately affects U.S. investors and consumers "depends on the scale of the response by the Chinese government and central bank," Garcia continues.

To date, China has allowed its currency to trade at the lower end of an established trading band with the dollar; "now I think the band is looking increasingly tenuous," Garcia says in the accompanying video. "That means for it to loosen policy -- especially vs. other trading partners -- it might well have to depreciate its currency further" by widening or dropping the band. (Hey, if the Swiss can drop the franc's peg to the euro...)

Joseph Brusuelas, chief economist at McGladrey, does not believe China will abandon the peg because of the government's concerns about inflation, which can lead to social unrest. But it "does looks like the Chinese may let the yuan be devalued, gradually and orderly," he says. "That means cheaper prices for Chinese-made goods as the Chinese attempt to use exports to cushion the slower pace of economic activity."

Should even a modest devaluation of the yuan occur, expect more rhetoric from U.S. politicians about China unfairly 'manipulating' its currency, also known as the renminbi. Potentially, this could cause the Fed to end up "delaying rate rises or signaling a shallower pace after the first rise," according to Garcia, who stressed China's currency is only one of myriad factors the Fed will be watching.

Stepping back, the big question here is whether China's slowdown is sharp enough to prompt policymakers to reverse or slow recent progress toward transitioning China away from an export-driven economy to one based more on internal consumption, i.e. a rising class of Chinese consumers. The 'old' Chinese export model "adds to the world’s capital flows imbalances, which contribute to financial instability in the U.S., along with a corresponding effect on the balance of imports vs exports for the U.S.," Garcia notes.

Behind Canada, China is America's second-largest trading partner and the U.S. ran a $342.6 billion deficit with the Middle Kingdom in 2014, according to the Census Bureau. A weaker renminbi would exacerbate America's trade deficit with China but most observers believe the U.S. economy is strong enough to withstand China's slowdown, this morning's weak retail sales data notwithstanding.

"It will be enough to notice, but I don’t think it will have a material impact on the growth story in the United States," says Doug Handler, chief U.S. economist at IHS. "I'm not too worried about the difference between 7.5% growth in China and 6.5%. It's not material enough to change the story for the United States."

Garcia largely agrees and says "the biggest danger" China poses to the U.S. is "a meltdown of its financial system, and the societal fallout from that. If current easing policies help alleviate that, then they will have been worth it" -- for China, the U.S. and the world at large.


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