How do you scare an (impressionable) American? Explain that the Chinese economy is growing so quickly that it’s now by some measures the world’s largest, even though as recently as the 1970s China was a subsistence agriculture backwater while the United States was a superpower. Invoke the human tendency to assume that trends continue indefinitely, and it becomes evident that within a couple of generations your average Chinese will be exponentially richer than your average American.
We can take this dubious reasoning further. If over leveraging in the United States led to a financial near-disaster in 2007-2008, any Chinese equivalent would send the world careening into post-Industrial Revolution levels of prosperity. That’s the worry articulated by several pundits in the wake of sluggish Chinese stock markets and discouraging employment numbers. It’s also, like most news stories, considerably overblown. (For more, see: 4 Ways China Influences Global Economics.)
A Banking Sector as Free as Ours
America has its Big 4 banks: Bank of America Corp. (BAC), JPMorgan Chase & Co. (JPM), Wells Fargo & Co. (WFC) and Citigroup Inc. (C). China has its own Big 4 – Bank of China, Industrial and Commercial Bank of China, China Construction Bank and Agricultural Bank of China. The difference is that while the latter 4 are owned by the state and thus can rely on cash infusions from the government whenever need be, the former four are, well in that respect, they’re just about identical. And while the Chinese banks’ risk of default has officially increased in the last quarter, it still remains slim.
Where Does China Farm Jobs Out To?
Continuing the parallel, America has “lost” 6 million manufacturing jobs since 1998 and the ratio of Americans employed in manufacturing is barely a third of what it once was. “Lost” is in quotes for a couple of reasons. First, the employment market is dynamic. Jobs exist today that didn’t exist yesterday and won’t exist tomorrow. No reasonable person would expect the labor force to forever consist of the same proportions of people occupied in the same industries. Second, American workers remain the most productive on Earth, by a comfortable margin over several other Western countries. It’s relieving, not worrisome, that the American manufacturing sector can prosper with so few employees. Comprehending that requires one to think on an order beyond (jobs = good) and (more jobs = better). (For more, see: The 4 Biggest Chinese Banks.)
China might have far more people employed in manufacturing than the United States does, but that doesn’t spell trouble for the U.S. What does is when China starts losing manufacturing jobs of its own, because that could mean that aggregate demand for Chinese products is sinking. When the U.S. loses manufacturing jobs, much of the loss is attributable to advances in technology. Plus there’s Ricardo’s famous Law of Comparative Advantage, whereby the economy prospers most when each producer does what it’s best at. America is better at oil and gas development, transportation, healthcare, agriculture, and yes, manufacturing than China is at any of them.
But America can’t do everything. Better to farm out to China the jobs that can be farmed out. (Farming itself, of course, can’t.) And while Chinese labor is cheap compared to American labor, it’s priced out of the market compared to labor in India and Bangladesh. Jobs don’t merely travel to wherever labor is cheapest, otherwise there would be zero factories in Ohio and millions in West Bengal. Instead, employers hire where the most value can be added. That’s why plastic toys thrive in Chongqing, while Lockheed Martin Corp. (LMT) builds aircraft in Marietta, Ga. (For more, see: 5 Things to Know About the Chinese Economy.)
Chinese for Bear Market
The Shanghai Composite Index, China’s equivalent of the Dow, has fallen 48% in the last six months. However, that level does involve some cherry picking. We’re measuring from the index’s all-time zenith, and the index had gained just as much over the previous 6 months. Take away 2015 and its graph that resembles the Matterhorn, and the Shanghai Composite has been roughly consistent in value over the last five years. Either way, the drop was as pronounced, if not as sudden, as the drop in the Dow itself between late 2007 and mid-2009. No investor today is complaining that the Dow suffered any long-term damage from a pronounced whack on the head that sent overheated prices to a more sensible level.
For ordinary investors, a drop in the Shanghai index – even a halving of its value – ought to mean the same thing that a similar drop in a domestic index would mean. It’s a buying opportunity of the highest order. (For more, see: Impact of the Chinese Economy on the U.S. Economy.)
Of course, investors who leveraged when the Shanghai Composite was at its height are feeling a different emotion right now. If you borrowed to buy stocks in PetroChina Co. Ltd. (PTR) or China Petroleum and Chemical Corp. (SNP), known as Sinopec, you might be facing a margin call and a penurious future. Then again, if you’re reckless enough to leverage like that you deserve whatever happens to you.
The More Things Change
Which leads to the one fear regarding the Chinese economy that does have some legitimacy: derivatives, the same investment vehicles that get much of the blame for the Western global financial crisis. Some Chinese banks are lending out money under a – there’s really no more apt word for it – shell of derivatives in the attempt to create appealing balance sheets. Should these first and second-order securities eventually lose value, the Chinese government could be tempted (or forced) to devalue the yuan.
The next step in that baleful series would be that in terms of yuan, the Chinese government’s monstrous holdings of American debt – already $1.3 trillion or so – would increase. The good news, at least on this side of the Pacific, is that China has been selling off its pile of U.S. Treasuries over the past few months to raise cash anyway. (For more, see: Is China's Economic Turmoil Good for the U.S.?)
The Bottom Line
We’ve reached the point where China now suffers the same indignities that other major world economies do – stock market doldrums, reduced demand, risk of bank defaults, credit crunch, etc. Which isn’t necessarily negative, in the long term. It means that China has a large and influential enough economy that such movements are of great interest to everyone. Back when China had an economy the size of modern-day Lebanon or Sierra Leone, a poor Chinese economic performance meant little or nothing. But even a temporarily compromised large Chinese economy is better for the world at large than is a small one. (For more, see: Is Now the Time for Chinese Stocks?)