Almost seven years out of the 2008 Financial Crisis, the global economy has begun to show signs of modest growth and stability. In fact, the U.S. and other advanced economies anticipate abandoning quantitative easing and raising interest rates by the end of 2015 or early 2016. However, as many economies show signs of promise, the second biggest economy in the world, China has begun to falter. China has been the shining spot in the global economic landscape for the past 30 years, but 2015 has proven to be a challenging year for the nation. Over the course of the year, China has experienced plummeting stock markets, interest rate cuts and stagnant growth rates compared to years past. As the world has become more financially intertwined the persistent events plaguing China have brought anguish to U.S. investors. Since the U.S. and China's relationship is so extensive, Chinese turmoil has caused investors to fear spillover of dollar devaluation and deflation in the United States.
U.S. Dollar Devaluation
It is no big secret that following the 2008 financial crisis China financed a large portion of America’s debt. Currently, the nation is one of the biggest holders of U.S. debt—holding $1.3 trillion of U.S. debt. As long as China continues to hold a massive amount of U.S. debt, investors believe the U.S. economy is at the mercy of China. If the Chinese economy continues to deteriorate, a worst case scenario can arise where China begins to dump their Treasury holdings. Selling U.S. debt at a rapid pace would devalue the domestic currency, resulting in downward pressure on your portfolio. Since the majority of U.S. businesses rely on imported resources, a declining U.S. dollar would make resources more expensive and thus put pressure on profits and share prices. However, the U.S. Treasury remains the most stable and liquid asset China could acquire, so a sell-off would only occur to stabilize the Yuan.
Deflation
While China and the U.S. have not always seen eye-to-eye on diplomatic issues, the two countries have a strong relationship built on extensive trade. Two-way trade between China and the United States amounted to $590 billion in 2014. As the United States’ primary trading partner struggles with low growth, Chinese manufacturers have slashed prices at the fastest rate in six years. Recently, low Chinese growth has depressed oil and commodity prices, creating a potential deflationary spillover to the United States. With U.S. interest rates on the verge of increasing, importing deflation would make it difficult for U.S. exporters to compete in the global markets. While cheaper prices may seem attractive, in the long-term companies will be forced to cut prices to remain competitive, resulting in lower profit margins and equity prices. This chain reaction would cause the government to re-evaluate their decision to raise interest rates until consumer spending returned to normal.
Decreased Optimism
Over the past 30 years, the Chinese economy had boasted average growth of nearly 10% with peaks of 13%. As a result of this unprecedented growth, China has grown into the second largest economy in the world and one of the biggest consumers of raw materials; however, when the second largest economy begins to show signs of weakness, this has a spillover effect on the global economy. China’s sluggishness has led the nation to allow its currency to trade more freely, prompting a decline in commodity prices and trading rivals to devalue their own currency. This, in conjunction with slowing growth, has invoked a shroud of skepticism amongst U.S. investors.
Before these events, many believed Chinese economic data was all smoke and mirrors, perpetuated by the government’s inflated statistics to make the economy appear better than it was. China’s recent actions have not helped either, with U.S. investors under the impression the Chinese government helped inflate the stock market bubble, which appeared to erupt earlier this year. This in itself has led Chinese investors to retreat from the stock market and flood the U.S. real estate market, provoking inflating U.S. house prices.
The Bottom Line
China’s growth was predicted to pass the United States shortly. However, its recent blunders have caused investors to hold their breath. As markets throughout China have recently wavered, an economic slowdown in China is believed to be a catalyst to the economic turmoil around the world. Amid all the concern, China’s difficulties should not have long-lasting effects on the U.S. economy rather it is a hurdle China must overcome as it transitions from an investment led to a consumer driven economy.
