Trouble in China: A Conversation with McGladrey's Chief Economist

Talk of a Chinese slowdown and the worrying U.S. equities market have led many to question whether the broader U.S. recovery is on the brink of a downturn. These past few months have been especially concerning, with one of China’s most notable indices, the Shanghai Composite Index, down more than a third over the course of the summer. Worried about this precipitous fall, Chinese policy makers have begun to pump money into their economy to try to sustain growth. Unfortunately, Chinese markets have continued to slide, manufacturing data has become quite concerning, and commentators have noted the potential for spillover effects into the United States. The HPR spoke with Joe Brusuelas, Chief Economist at McGladrey, a large tax and consulting firm focused on the middle market, to clear the air and reveal the bigger picture.
Brusuelas primarily focuses on the G20 economies, looking at public policy revolving around central banks and financial markets. As someone involved with market activity day in and day out, Brusuelas went beyond looking at the official Chinese economic data (in his words, “one should always approach official [Chinese] data with a grain of salt,” as it could be manipulated by the state) and instead shared some of the lesser-known metrics that he tracks.
“Demand for electricity in China is probably the best indicator of growth. Sentiment data [by contrast] can be quite erratic, and does not always reflect what’s going on in China,” he argued. “[Electricity demand] is growing around three percent [per year]. That’s far less than what you need when you are an emerging market. In some ways, China is moving toward a recession.”
Brusuelas sees conditions in China as more dire than other insiders do. Tim Cook, the CEO of Apple, recently commented on the strength of Chinese demand for iPhones as a sign that the economy was still on track. But if Brusuelas’ assessment proves correct, demand for goods ranging from mobile phones to commodities could suffer greatly. In fact, carmakers like BMW have already revised down sales growth estimates in China. Greater weakness will only compound the downward spiral in other industries.
It is precisely this downward spiral that concerns U.S. investors the most. Globalization over the past few decades has connected markets in a complex web of transactions, and large-cap companies in the United States (like McDonald’s, among others) have responded to saturated American markets by looking abroad. If conditions in emerging markets—of which China is the focal point—deteriorate, these American companies and western markets in general could lose a great deal.
Brusuelas pointed out that spillovers effects are already being realized in other markets. “One can take a look at the Australian economy or the Brazilian economy, and see the residual effects of slower Chinese growth.” Nevertheless, there is some hope for American markets. Brusuelas noted:
“[The Chinese market] accounts for less than one percent of U.S. GDP, so the [United States] is not necessarily exposed. However, due to financial leakages and the overexposure of some investors to the international sector, the turmoil in Chinese financial markets did have a material impact on U.S. financial markets,” he explained. However, Brusuelas believes that “over time, U.S. financial markets will decouple and exposure to China and emerging markets will reduce. More of an emphasis will be placed on Anglo-American economies, with specific exposure to American domestic companies that pay dividends and have little or no [Chinese] exposure.”
Long story short, there may be negative effects in the short term, but in the long term investors stand to gain. Even though the weakness abroad will eat away at equity, investors can always turn to the resilient American companies that are much less volatile and typically more lucrative in the long run.
Nevertheless, as the famous 20^th century economist John Maynard Keynes once put it, “Long run is a misleading guide to current affairs. In the long run we are all dead.” In other words, investors do not have infinite time horizons, and many are suffering losses in the present. While the long road ahead is certainly reassuring, short-run solutions are what will really make the difference between a serious financial catastrophe and a slight contraction. The Chinese recognize this, and their policy makers are certainly under immense pressure.
Unfortunately, China faces a difficult short-term hurdle. Brusuelas mentioned that the Chinese “have to deflate three bubbles simultaneously while the economy is transitioning from one based on an export-oriented model to one based on an inward-oriented, consumer market. The three bubbles are residential investment, commercial investment, and the equity markets.”
In Brusuelas’ view, their options are limited: “The Chinese have little or no choice but to attempt to achieve gradual and orderly depreciation of their currency, in order to obtain growth via the export panel.” Already, “the Chinese have spent well over $250 billion to cushion the depreciation and liberalize their currency.”
Though these costly measures have yet to turn the course of the economy, Brusuelas expects more to come. “When the policy shifted from equity purchases and currency purchases—buying Yuan and selling the U.S. dollar—to cutting the reserve rate, that was an indication that the Chinese fiscal and monetary authority are very concerned about the spillover from deteriorating financial conditions into their real economy. One would expect by the end of this year that you would have a very potent fiscal package from Beijing to get the economy moving again.”
The broader economy—not financial markets—is a country’s top priority when facing a contraction. While many prefer to get lost in the percentage moves in stock indices and derivative contracts, governments are the ones providing the ultimate backstop to make sure the moves in these tickers do not end up costing real jobs. With a large enough stimulus package, China may be able to keep an impending catastrophe at bay.
This is by no means a new lesson. China’s future may be bleak, but so too was the United States’ and Europe’s half a decade ago. A battle-proven central bank stimulus coupled with fiscal measures worked together to provide temporary relief that carved out a path for longer-term development. Although the current outlook in some ways looks bleak, if CCP officials can follow the Western example from 2009, China may be poised to make an eventual comeback that leaves all market participants better off.
Image source: Wikimedia // Yongxinge