On Decoupling: Could China Save the Day?

For many years, the U.S. economy has grown through expansion in private consumption, absorbing excess output from emerging economies. As the financial system and households are experiencing the credit crunch, many economists and market players see rising odds in recession, but they are divided whether emerging economies, China in particular, can “decouple” from the largest economy in the world and sustain their growth. U.S. Treasury Secretary Hank Paulson recently called on China to live up its global responsibility by maintaining growth while relying less on exports and more on domestic consumption.

By examining the key contributing factors to the economic growth in China, I will weigh the impact of reduced U.S. demand to the Chinese economic and suggest that decoupling could occur to a large degree but it is unlikely that it would provide a meaningful boost to the U.S. economy. Lastly, I will discuss some high-level investment considerations based on the analysis.

Export

For the past four years, it’s widely known that export has been a key driver in China’s economic growth. With a 11% plus annual growth in GDP, export accounts for more than a third of that growth. Based on the estimate from China’s central bank, every 1% drop in U.S. economic growth translates into a 6% fall in Chinese exports. Suppose that the U.S. economy grinds to a halt, the impact to the Chinese export sector would be devastating, but the Chinese economy as a whole would well weather the downturn. This might be surprising to those who have much anecdotal experience about Chinese exports. What people tend to overlook is that China imports almost as much as it exports, so the contribution to the overall GDP from net export accounts for only 10%. Excluding export growth, China would still have more than 7% growth in real GDP year over year, a rate that any country would be happy to have.

Investment

Fixed investment, on the other hand, is the largest component in the GDP, accounting for 40% of the overall GDP and another third of the economic growth. To cool off investments, the Chinese government has been taking aggressive administrative measures to tighten liquidity, such as lifting commercial bank’s reserve ratios and lending rates many times this year, and clamping down non-bank lending. However, companies are finding ways to circumvent the tightening policies and plowing back cash earnings into new investments at a record level. The companies affected are mostly private businesses that rely heavily on bank lending to run business, such as real estate developers and small-to-medium businesses. Besides domestic sources, foreign private equity funds and Gulf petrodollars are also eager to get their hands on hot investment opportunities, intensifying the problem of excess liquidity.

It is quite possible that investment could become an even bigger factor driving the economic growth in the near future. On the other hand, if the flood of investment mostly goes into building out the export sector, this investment-led growth is unlikely to be long-lasting.

Private Consumption

Household consumption in China is the lowest among countries in the region. Most Chinese policymakers agree with Secretary Paulson that on balance consumption should play a bigger role in economic growth, but it is unlikely that consumer spending will pick up much pace in next few years. In fact, as a percentage of GDP, it dropped from 46% in 2000 to 36% in 2006 and its contribution to growth remains muted. Despite very-low-to-negative real interest rates, consumer savings have actually increased. This counterintuitive phenomenon reflects the social economic changes undergone in China in the last decade, which receive little attention from outsiders but fundamentally affect how Chinese consumers make budgeting decisions. Gone are the cradle-to-grave social welfare programs, and consumers are forced to save large sums for uncovered or unexpected expenses. For instance, only 17% of the population are covered under any basic government pension scheme, while only 14% have unemployment insurance. Without much confidence in the social supporting systems, the saving rate will remain elevated for the foreseeable future.

Furthermore, growth in consumer spending would provide limited relief to the U.S. economy, because most consumer goods manufacturers in the U.S. have either gone out of business or moved their operations to low-cost countries, like China. In the latter case, the economic output is counted towards the countries that manufacture the goods rather than the U.S., because firm ownership is irrelevant when calculating GDP.

Decoupling, Yet Not Saving The Day

Not until the last decade, China had been a rather closed economy as a result of the decades-long “self-sufficient” economic policies. The astonishing growth in export largely stems from a very low starting point. Meanwhile, China has to import large quantities of capital goods, energy, and raw materials to feed the export growth. In fact, import offsets most of the economic growth that export contributes to. The slowdown in the U.S. economy will lead to contraction in Chinese export, but at the same time China needs to import much less to produce these goods. On the margin, China’s economy will decouple from the U.S. slowdown to a large extend and continue its growth as other economic drivers remain in place.

One way to reinvigorate the U.S. economy is to boost its export, particularly in industries that the U.S. still has a comparative advantage, such as high-tech goods and services. Unfortunately, many such high-tech goods and services are off-limits to China for political reasons. Without structural changes in the U.S. export, it’s unlikely that the U.S. economy could benefit much from China’s continuing prosperity and its increasing appetite for imported goods.

Investment Considerations

U.S. Capital Goods Companies
The large growth and weight in fixed investment as a percentage of GDP presents a lasting force that drives demand in capital goods, particularly industrial equipment and infrastructure. U.S. firms that offer superior engineering products and expertise could benefit from it.

European and Japanese Consumer Brands
Consumption growth follows similar paths among developing countries, evolving from basic household needs to the pursue of diverse life styles. With more disposal income, Chinese consumers will start shifting from what they need to what identify them, buying more electronics, cars, and luxury goods. Strong European and Japanese consumer brands have long been viewed as high-quality, high-fashion, and leading-edge by Chinese consumers.

Agricultural Chemical and Natural Gas
More disposal income also naturally leads to more consumption in protein and other food on the top of the food chain. We have seen that the demand in meat and dairy products has been increasing faster than people expected. While it is difficult for average investors to invest in farms or commodity futures, it is possible to invest in companies along the value chain. To feed more stocks, we need to plant more crops, which in turn need more fertilizer. And it takes a lot of natural gas to make fertilizer. Agricultural chemical companies and natural gas producers appear to be the beneficiaries in this macro trend.