How China’s economic woes will affect the United States: A view from East Asia.

Chinese economyIt’s only natural for Americans to be somewhat spooked about what’s happening in the financial markets, what with thousand-point drops on the stock exchanges and all.

It’s even more disconcerting to realize that the forces in play are ones that have little to do with the American economy and a lot more to do with Europe and China. (China in particular, where bubbles seem to be bursting all over the place with the fallout being felt everywhere else.)

In times like this, I seek out the thoughts and perspectives of my brother, Nelson Nones, an IT specialist and business owner who has lived and worked outside the United States for nearly 20 years — much of that time spend in the Far East.

To me, Nelson’s thoughts on world economic matters are always worth hearing because he has the benefit of weighing issues from a global perspective instead of simply a more parochial one (like mine).

Nelson Nones
Nelson Nones

Yesterday, I had the opportunity to ask Nelson a few questions about what’s happening in the Chinese economy, how it is affecting the U.S. economy, and what he sees coming down the road. Here are his perspectives:

PLN: What is your view of the Chinese economy — and what does the future portend?

NMN: I’m a real pessimist when it comes to the current state of the Chinese economy. I also think the Chinese will turn on themselves politically as their economic house of cards is collapsing — so look for a sharp upturn in political and social turmoil as well.

Just as the bubble burst in the U.S. and Europe in 2007-08, it’s bursting now in China — and the rest of East Asia (South Korea, Japan, Thailand and Singapore) are going to get caught in the fallout because of the extent to which their economies are reliant on trade with China.

 PLN: What do you look at, specifically, for clues as to future economic movements?

NMN: The barometer to watch is the price of oil. It plummeted in 2007, presaging the “great recession” in the West.

untitledOil prices began to drop again in 2014.  The U.S. oil benchmark fell below $40 per barrel on August 24, 2015, a level not seen since 2009. I believe the underlying root cause is a sharp contraction of East Asian demand due to the economic bubbles bursting over here, coupled with persistently high supply as Middle Eastern oil exporters compete against American producers to protect market share.

PLN: How will these developments affect the U.S. economy?

NMN: The oil bust will continue in the U.S., dragging the economy down. But energy prices will be lower, buoying other parts of the American economy.  For instance, the domestic airline sector will benefit and consequential demand for Boeing jets will grow.

U.S. imports — specifically, imports from China and the rest of East Asia — will become cheaper as China and other countries allow their currencies to fall in order to protect their exports.

This is probably a “net-neutral” for the US economy in that American exports will be hurt due to the relatively stronger U.S. Dollar, but American consumers will benefit from lower prices. So, the direct economic impact is likely to be mixed.

PLN: So, why worry?

NMN: The real risk, in my opinion, is a global liquidity crisis. Over the past quarter-century, China and other East Asian countries have accrued enormous wealth. But they didn’t hoard their newfound wealth; they invested it both domestically and overseas.

China has invested ginormous amounts of cash in domestic infrastructure and housing. That money is already spent, and a sizeable part of the investment has already gone to waste in the form of corruption, new housing that nobody wants, underutilized transport infrastructure and non-performing loans made to inefficient state-owned enterprises. 

All of this will eventually need to be written off (that’s why their bubble is bursting).

But China has also invested lots of money in overseas financial instruments. Think of the Chinese as the folks who financed the Federal Reserve’s Quantitative Easing program as well as Federal debt in the U.S. But as the Chinese run out of cash at home, they will increasingly need to liquidate their overseas investments just to pay their bills.

This poses a very real threat to the fiscal stability of U.S. and European governments, and to the supply of capital in U.S. and European financial markets.

The Federal Reserve is likely to be caught in a double-bind. On the one hand, if the Fed raises interest rates in response to the reduced supply of capital (as it is widely assumed they will, later this year), they risk choking off the tepid U.S. recovery currently underway.

This would also cause the U.S. Dollar to strengthen further, thereby exacerbating the negative impact of the Chinese bust by making U.S. exports less competitive in global markets.

On the other hand, if the Fed leaves interest rates where they are (basically zero), then they won’t be able to attract enough capital to roll over the public debt that the Chinese are trying to liquidate. In other words, the Fed risks a “run on the bank.”

The Fed can deal with this by printing more money (more or less what the Chinese did in 2007-8), but this would inevitably introduce inflationary pressures in the U.S. It would also lengthen the time it takes for the Chinese to right their ship, because it will put downward pressure on the U.S. Dollar, thereby constraining whatever the East Asians can do to boost exports.

My guess is that the Federal Reserve will “blink” and keep interest rates at zero (and also print more money to pay off the Chinese) in hopes that (somewhat) cheaper imports will offset (some of) the inflationary impact of printing more money.

This is equivalent to kicking the can down the road.

PLN: Do you see any impact on the 2016 Presidential race in the United States?

NMN: As a result of kicking the can down the road, I foresee little impact on the 2016 U.S. Presidential race — but watch out in 2020 when the hangover is well underway.

Alternatively if the Fed raises interest rates, I suspect the Democratic Party candidate will be more vulnerable because the short-term economic pain will be much higher in the U.S. The incumbent party will get most of the blame. Fair or not, that’s just the way bread-and-butter issues play out in American politics.

PLN: What about unrest in China — might that have political repercussions in America? 

NMN: The way I see it, political or social turmoil in China will have zero impact on the U.S. Presidential race. Americans of nearly every political stripe or ideology dislike or distrust Chinese governance, yet unlike the “China lobby” of the Cold War era, they have no appetite to intervene in what they rightly perceive to be internal Chinese affairs.  

Or they’re clueless about events in East Asia. Or they just don’t care.

So there you have it — a view from the Far East. If you have other perspectives, please share them with our readers here.

______________

Update (8/28/15):  A few days after this post was uploaded, I received this follow-up from Nelson:

Just as I had predicted, check out this link.  Federal debt is getting more expensive to finance, because the drop in demand for U.S. Treasury bonds (caused by the Chinese liquidation apparently underway) is driving yields up.  According to the article, “The liquidation of such a large position, if it continues, could wreak havoc on the Treasuries market.”
Now look here:  http://www.bloombergview.com/quicktake/federal-reserve-quantitative-easing-tape. It’s an easily understandable explanation of how the Federal Reserve’s quantitative easing (QE) program worked.  Essentially the Fed, like China, stepped in to buy Treasuries also. The Fed also bought mortgage-backed securities.
The Fed’s purchases of Treasuries and mortgage-backed securities now make up ~85% of the Fed’s assets.  The Fed hasn’t indicated what it will do when these assets mature, but if it doesn’t roll over this debt (or a portion thereof) then we can expect Treasury yields to rise yet again. Even if the Fed decides to keep interest rates where they are, at near-zero, rising Treasury yields could bring on a liquidity crunch within the private sector as capital is increasingly drawn away from private investments (loans, corporate bonds and equities) to government-issued bonds paying higher yields with little risk.
Facing the Chinese liquidation, this is why I suspect the Fed will opt to roll over its holdings of Treasuries and mortgage-backed securities, and keep interest rates at near-zero, at least through the 2016 Presidential election cycle.  The Bloomberg article cited above describes QE as an alternative to printing more money, but in the end it’s really the same thing.

One thought on “How China’s economic woes will affect the United States: A view from East Asia.

  1. I understand Nelson’s comments, and his analysis, and agree with some of them.

    Yes, the U.S. market is ALWAYS touchy about certain trends, as in China’s problems/devaluing-of-the-yuan, plus the inevitable slowdown in their own economy.

    We should add that the bull market has been going since 2009, and many of the indications are that it’s truly time for not just a slowdown, but a pullback overall. Also, our interest rates used to matter more in the ’70s or ’80s — much more than they do now. There’s hardly any tendency towards measurable inflation, let alone the type that would affect the gargantuan economy we have nowadays.

    Of course, there are other influences on stock prices and markets, in general … here and abroad. But our market often, these days, corrects itself from becoming too-radical.

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