My dear Friends,

this week‘s Chinese Communist Party Congress and the very likely announcement of Mr Xi’s third five-year term as

is not the only headline coming out of China taking precedence over any other global news! But the party’s decision to delay the release of its third-quarter GDP data. Is this proof that China’s economy is really slowing down?

But why should you or I, for that matter, be concerned if China´s economy slows down? After all, China is still considered an emerging market, so this will surely have little effect on the world or my investments!

As you will see – this is not the case

How it all started

Like most economies, China’s economy has continuously been up and down for millennia. Ancient China’s economy, like many others at that time, was based on agriculture. Most Chinese families lived in small farming villages of a dozen or so families.

Between 1400 and the 17th century, the Ming Dynasty‘s reign, however, China was one of the world’s richest and most modern countries in the world.

China’s economic downfall began with the Qing dynasty’s rule (1644–1912). Mainly due to the introduction of an isolationist policy. Endless civil wars and the reign of provincial warlords further weakened the Qing Dynasty.

The Decline

Several colonial superpowers like France, Germany, the United States and Japan saw their opportunities, seized several ports, started the Opium war, and finally defeated China in two wars. The primary goal was to trade; the port cities, however, left a major long-term impact on the Chinese economy, society, and culture.

China had become the puppet of their colonial masters.

1912 the Qing Dynasty falls, and China becomes a Republic. After its founding, the Republic experienced many trials and tribulations, including being dominated by elements as disparate as warlord generals and foreign powers. This period is marked by frequent wars, famine and turmoil. This is a period of instability and economic decline.

Corruption and Hyperinflation

The collapse of central authority caused the economic contraction that was in place already during the final Qing decades to speed up. This was only reversed after China reunified in 1927.

The Chinese Nationalist Party – Kuomintang – under the rule of Nationalist Generalissimo Chiang Kai-shek took over.

In 1937, Japan invaded China, and the resulting warfare laid waste on China. The Japanese quickly conquered most of the prosperous east coast and imposed a brutal occupation on the civilian population.

The rampant corruption of the Nationalist Party, hyperinflation due to the over-issuing of currency and the drain on the civilian population caused by the war effort stirred mass unrest throughout China.  

Inflation had begun with the start of the Sino-Japanese War and had worsened to chronic hyperinflation by the middle of the 1940s. The inflation problem was significantly based on the Nationalist Party‘s failure to restore revenue sources and its printing of money to finance its deficit.

By 1949-China has experienced 150 years with zero GDP growth for 150 years!

Walking on two legs

The Communist Party of China (CPC) began economic reform immediately after it ascended to power on October 1, 1949.

The chief goal was to restore the economy to a working order and to bring inflation down.

These objectives meant industrialization, improving living standards, narrowing income differences, and production of modern military equipment.

As the years passed, the leadership continued to subscribe to these goals. But the economic policies formulated to achieve them were dramatically altered on several occasions. Mainly in response to major changes in the economy, internal politics, and international political and economic developments.

In the aftermath of the Korean War (1950-53), the government adopted the Soviet-style five-year plan model, focusing on industrialization. The model, yielding mixed results, was quickly abandoned and replaced with a model known as the “walking on two legs” policy.

The idea was to allocate resources equally to modernize industrialization and agriculture. This model was derailed by Mao’s “Great Leap Forward” movement, which proved disastrous for the country, pushing the economy almost to the brink of disaster and causing massive starvation.

It remains, however, to be said during this time, China’s GDP grew at around 3% per annum. This was possible because of state ownership of certain industries and central control over planning and the financial system. This enabled the government to mobilize whatever surplus was available and greatly increased the proportion of the national economic output devoted to investment. Nearly 25% of China´s economic surplus was reinvested.

Big Changes

The World Bank positively assessed the Mao era reforms. Mao Zedong died in September 1976, and Deng Xiaoping became the new leader.

At the annual conference on the 11th of September 1978, the Chines Communist Party pledged to reform the economy further:

China, home to 20 per cent of the world’s population, began its final transition by opening up its economy to the outside world in the 1980s. Since then, the dragon nation has grown by eight per cent yearly.

In 2010 it overtook Japan as the second-largest economy in the world.

Xi-nomics

When Chinese leader Xi Jinping came to power in 2012, he unveiled a sweeping vision for the “great rejuvenation” of the country — a “dream” that would make China powerful and prosperous.

Xi, however, never saw economic growth as imperative the way his predecessors did. His focus is reasserting government control of many aspects of people’s lives, with widespread economic impacts.

Today, China’s greatest problem is its leadership’s heavy-handed efforts to control the people and the economy.

China’s economic gains began when Mao’s successor liberalized economic regulations. Farmers were allowed to leave collectives, small businesses were tolerated, and foreign investment was welcomed. As a result, China enjoyed the greatest alleviation of poverty in world history.

Increased regulatory scrutiny, most notably in the real estate and energy sectors, is the main drag on economic growth

Allianz Trade Global

Ten years later, Xi has transformed China. He has consolidated the country as a force on the world stage, with an expansive economic footprint, a modernizing military and rising tech and science abilities.

The most optimistic scenario under current leadership would be slow growth. Far slower, however, than in recent decades.

The great Crunch

China’s nearly two decades of rapid expansion appear to be coming to an end.

Massive infrastructure investment and real estate development, China’s preferred boosts for much of the last decade, look ill-equipped to deal with the current slowdown on the contrary.

The covid pandemic, the effects of climate change and a range of internal economic difficulties- like seriously indebted local governments and distressed banks have a devastating effect on the country‘s economy.

Centralized planning has traditionally helped China avoid the worst of major global recessions. This time, the scale of the problems far outpaces the policies that might fix them.

Growth has stalled, youth unemployment is at a record high, the housing market is collapsing, banks are defaulting, and companies are struggling with recurring supply chain headaches. To add to the problem, China‘s population is heading for a massive labour shortage and over-ageing due to China‘s one-child policy, introduced in 1980.

The situation is being made much worse by Bejing’s adherence to a rigid zero-Covid policy. Nationwide, at least 74 cities had been closed off since late August, affecting more than 313 million residents. Goldman Sachs estimated that cities impacted by lockdowns account for 35% of China’s gross domestic product (GDP).

The Party is running short on both time and available policy levers to address many of the most pressing systemic threats to China’s economy,”

Craig Singleton,Foundation for the Defense of Democracies

Purchasing Power

In 2021 China was estimated to be the largest consumer economy as measured in purchasing power parity (PPP) terms. China has become the biggest market for a range of industries, from luxury goods to automobiles.

Remember that 20% of the world‘s population lives in China – that makes many consumers. If they become less hungry for international goods, the global economy has a problem.

China under economic strain is a relatively new phenomenon for the rest of the world. Developed and developing countries alike have grown used to Beijing’s seemingly insatiable appetite for their products.

The purchasing manager’s index fell in the latest report. Home sales declined 40% from a year ago. GDP rose by just 0.4% over the past four quarters, compared to the national target of 5.5% growth.

Estée Lauder, the US cosmetic company, expects its global sales to grow between 7% and 9% year-on-year, down from a previous range of 13% to 16% outlined in February. Why? Because sales in China fell.

Starbucks suspended financial forecasts because ” the situation in China is unprecedented”. China is Starbucks’ second biggest market.

Kering, the French Luxury Group owned by Francois-Henri Pinault, Salma Hayek’s husband- – complained about sharp falls in sales in China. China is their largest consumer market.

“Frankly speaking, consumers right now are not worried about buying lipstick or coffee,” said Cavender. “They’re really much more focused on getting necessities.”

Jean-Marc Duplaix, CFO, Kering Group

China is the second biggest market for Tesla, a US electric car manufacturer. Tesla is reportedly reevaluating how it sells electric vehicles in China and considering closing some showrooms in cities like Beijing.

Volkswagen, the German carmaker, reported a massive drop in sales for 2021-a decrease of 14 per cent.

Exporters

From a global demand perspective, exporters to China could suffer, particularly those exposed to the construction and metals sectors.

So, yes, a serious downturn in China‘s economy will certainly have a trickle-down effect on the global economy.

Amongst the world‘s top 100 companies, exports to China make up 15% of their total revenues in the US and 12% in Europe.

Beyond the short to medium term, countries dependent on Chinese demand will need to deal with its adjustment to a lower growth regime -between +3.8% and +4.9% – and will have to deal with the risks this bears for their economies.

For the most export-dependent nations — not only South and Southeast Asia and Africa but also Europe — the effects of an already-slowing global economy will be amplified by a shrinking China market.

The world‘s Factory

From 1992 to 2002, China implemented a series of very attractive incentives for foreign companies and investors to set up manufacturing hubs in China. This had a massive impact on China’s economic growth.

For many years now, China has been the world’s factory. Even in 2020, as other economies struggled with the effects of the pandemic, China’s manufacturing output was $3.854 trillion. This accounts for nearly a third of the global market.

Cheap and plentiful labour was the prime factor in China’s rise as the ‘world’s factory. Besides this, an abundance of raw resources and low environmental regulations made it easy for any enterprise, local or foreign, to grow.

Many multinationals, like Apple, Microsoft, Tesla, and Volkswagen shifted substantial parts of their production to China. Frankly, the world‘s fashion industry would not exist without manufacturing hubs in China.

With the capacity to produce anything from low-cost footwear to high-end biotech, China’s grip on the supply chain is unmatched.

From a global supply perspective, the Chinese economic slowdown could further raise the cost of trade and global input prices, lengthen delivery delays, and even worsen production shortfalls in the US and Europe.

Belt and Road

China’s Belt And Road initiative already grapples with a mounting debt crisis. Sovereign-debt distress spreads in several countries along the BRI, prompting China’s first overseas debt crisis as it grapples with a mounting pile of nonperforming loans and increased scrutiny of how Chinese lending has exacerbated economic pressures on vulnerable governments.

How an increasingly shrinking Chinese economy will be able to make available funds to pay for distressed loans and all the ambitious projects it promised to fund is unclear.

“China is also under growing economic pressure at home now and is becoming more hesitant to lend to risky countries. This has opened a new phase of the BRI.”

Alicia Garcia-Herrero, Chief Economist, Natixis Investment Bank

The poorest have also become dangerously dependent on China’s trillion-dollar Belt and Road Initiative and the lending spree that came with it — which was meant to rival the World Bank and International Monetary Fund (IMF) as a source of capital and infrastructure. All these China-related opportunities are now being thrown into question.

The distressed sovereign funds in Central Asia, Pakistan, Africa, South America, and some European countries will send more than just a ripple effect through the world´s financial markets.

Impact on the rest of the world

None of this is to suggest that the sky is falling in China or that some sort of cataclysmic economic collapse is imminent or even likely. But the slowdown is real, and it is going to have longer-lasting effects than downturns of the past. 

There’s a huge and less well-understood ripple effect spreading around the globe: Countries large and small are not prepared for the fallout.

The Chinese economic slowdown could weigh on global capital markets, especially in the US and Europe.

Securities-Treasuries

The Chinese Government´s foreign securities (government debts) amount to 25% of the financial assets in Germany, 28% in France, 40% in Italy and Spain, and 55% in the US.

Should China stop acquiring foreign securities/treasuries, this would be bad news for countries trying to borrow money.

China has begun to sell foreign debt, especially US debt. The official version is to diversify more. In case China decides to offload too many securities/treasuries, we would have a worst-case scenario.

Markets would fail to absorb these securities, they would become worthless, and governments would be unable to repay their debts.

This, however, would be as damaging to China as it is for the issuing countries- so unlikely.

Cooperate Bond Markets

Looking at financial markets, spillovers from China to the rest of the world are likely to happen in equities rather than corporate credit.

The corporate bond market has been under pressure over the past few months. The already wobbly real estate market in China could see further risky real estate developers go bust; this, in return, would hit the developer’s offshore bonds as well. They would default unless the Chinese government would bail the issuer out, as they have done before.

Chinese equities now have a sizeable impact on US markets – which set the tone for global equities. The increasing liberalization of Chinese capital markets made foreign ownership of Chinese equities and bonds possible.

So, a crash in Chinese financial markets today could result in a broader and stronger fallout for global markets.

A special relationship

The economic relationship between China and the U.S. is extremely symbiotic. A China slowdown will affect the U.S. in three main areas: trade, the U.S. debt, and the value of the U.S. dollar itself.

So, China’s growth slowdown could affect America’s ability to issue new debt. China is the second-largest holder of U.S. Treasurys. As China’s exports to the U.S. decline, its government has fewer dollars on hand to purchase Treasurys. The Chinese government gets these dollars from Chinese companies that receive them as payments for their exports. 

As China’s demand for U.S. Treasurys falls, so will the demand for the dollar. Treasurys are one measurement of the dollar’s value. As a result, the value of the dollar against the yuan could decline.

Since May 2021, China’s holdings of U.S. debt have fallen below $1 trillion for the first time in 12 years amid rising interest rates that have made US Treasurys potentially less attractive.

The decline in China’s share also has been attributed to Beijing working to diversify its foreign debt portfolio.

Quick Read

The sky is not about to fall in China, nor are we heading for a collapse of the global economy.

But the slowdown is real, and it is going to have longer-lasting effects than downturns of the past.  There is a high chance that there is a financial spillover on the rest of the world.

World leaders will need to rethink their own economic plans to adjust to a world that can no longer count on China’s growth to fuel their own prosperity.

What can we do as investors? As always, stay informed, diversify your portfolio and watch the markets. Remember,

a) nothing lasts forever – there is always a light at the end of the tunnel.

b) While one asset class takes a hit, others will benefit no matter what the economy does.