China Capital Markets Research

The U.S. Government Shutdown and Its Impact

The shutdown of the U.S. government ended as the two U.S. political came to an agreement to delay the decision to January-February of 2014. This means that the global market instability will likely still be on-going until the beginning of next year. This also means that the U.S. market may not be as lucrative and attractive as before, as critical decisions regarding the debt ceiling and government funding are still not solved.

It is important to figure out the impacts of the incident on Chinese economy, as the U.S. and China are the world’s number 1 and 2 economies with strong ties. The index trends in East Asia, oil consumptions and imports by China, and geo-political status of China are all important aspects to consider to understand the impact.

Market Change after the End of Shutdown

The Chinese stock index fell right after the announcement of the end of the government shutdown, while other East Asian and Southeast Asian market indexes rose. Although, it is hasty to conclude that China had served as a ‘refugee market’ or as an alternative to the U.S. market just from that factor, one could draw certain implications that people were shifting their investments in and out of the US / China as a the appeal of each market shifted.

U.S. – China Relations from multiple angles

According to the U.S. Energy Information Administration’s latest report, China surpassed the U.S. in terms of oil imports in September, due to oil consumption surpassing production. Part of the reason behind this is that the U.S. has been decreasing the total import of crude oil – China is replacing the U.S. demand. If this trend continues, and the decrease of oil price also continues, China will benefit from the outcome by stabilizing the export production cost, but at the same time become more susceptible to the oil price. The economic ties with the U.S. has to be a factor here, as crude oil imports to China are used for the refined oil products and the production of manufacturing goods that go to other nations around the world. Since the U.S. is the biggest individual nation in terms of absorbing Chinese exports, the susceptibility will only be counterbalanced when Chinese exports are sold with minimum hindrance.

The ultimate factor, however, is the sovereign debt of the U.S. held by China. In 2011 China already became the top U.S. government debt holder, accounting for the 8 percent of total U.S. public debt. Even in percentage terms the figure is very high. As long as the U.S. has the economic power to pay back the interest and return the principal for the matured bonds, both the U.S. and China have little to worry about. However, the current talks on debt ceiling and budget talk have changed the atmosphere. For the U.S. when a single country has such high debt in time of financial instability is one more thing to worry about. For China, it is now holding a potential time bomb – even though the chance of the U.S. default is very low, the lessened credibility of the U.S. government bonds means the future investment channel is narrowed. The portfolio of Chinese government requires changes, and the currently-held debt needs to be reevaluated in terms of the possibility of return. Chinese government needs to diversify its risk coming from the U.S. instability.

Geo-Political Movements of China

As China is a well-known politically stable country with one party system, at the moment of the U.S. instability, the characteristic is clearly a benefit to China. However, in modern economy, nations maintain close political and economic relationship. This means the U.S. instability will have a likely negative impact on China.

Then the question we have to ask is how much impact the U.S. instability will have on Chinese economic growth. It is possible that China would not be able to enjoy high growth rates it used to for the next 3 to 4 months, as the U.S. is one of the top 3 markets for China. If the U.S. market is not able to consume as many goods as it used to be due to the instability, China will face further reduced exports. These exports alone represent about one fourth of the total GDP, and the net export is about one eighth of the total GDP. Therefore, if China export to the U.S. slows by a considerable amount because of the instability, the consequence for China will not be great. Whether it was done to counter such consequence is not clear, but the president Xi and the premier Li’s meetings with the leaders of ASEAN nations can be seen as a type of insurance for China. This will not only increase the geo-political strength of China, thus further stabilizing regional politics, but also create more economic ties with the region to divert exports and investment channels.

However, so far the “magnet of economy” is still at the U.S. market, and the power of the magnet is very strong. In other words, the determinant of global market trends is the U.S. and that fact will be the key to the Chinese economic prospects. The geo-political factor of Southeast Asia is not yet strong enough to counterbalance the current instability formed in the U.S. market and politics.

Possible “Next Steps” for China

The Chinese market may not show a sudden change, but the prolonged instability will certainly diminish the economic strength that China has been showing for a couple of decades. This means China has to prepare for certain changes that could affect its future growth. Before the shutdown, there had been worries on the U.S. Federal Reserve’s (the Fed) tapering on quantitative easing. Now the concern on the U.S. budget and debt ceiling talks adds more worries to developing nations. Nations including China will have to worry about whether to focus on development as they have been doing, or to focus on stabilizing the domestic economy and strengthening the weak links within their own economy. As the government shutdown caused economic instability, the Fed will most likely continue its quantitative easing to secure economic conditions for now. That does not mean the instability of the Fed’s tapering is removed, because it is like the status of the U.S. budget talk: the quantitative easing is only a temporary solution.

Even though China has a huge domestic market, in time of economic instability, the driving force of economy is hard to find. Export is not going to help China go through this hard time as the whole world is suffering together, and domestic consumption growth is still up in the air. In September, Chinese exports faced an unexpected year on year drop. When looking at the income of Chinese people, that does not seem to help increase domestic consumption. Other possible economic boosts such as government spending or investment are still viable options, but the question is “how long and how much the Chinese government and corporates are willing to put money into it?”

Not only that, China also faces the question of liberalization of the market. China has shown strong commitment to liberalize and open up further to the global market, especially in financial and trade sectors. The recent interest rate reform and Shanghai Free Trade Zone were two of the examples that have shown Chinese commitment through action. Since there is instability in the global market, the economy will not be as energetic enough as Chinese government expected it to be for its liberalization process. This means that China can cut its effort down to open up the market and slow down the pace of economic expansion. This could be a problem if the investors around the world, who think China will still show strong growth, find out about the policy changes in China. Even if the investors have anticipated the slowdown, the actual impact of Chinese slowdown will be massive, considering the size of Chinese economy.

Also, Chinese government external debt has increased significantly in recent 10 years, more than tripling since 2002. China has funded many projects through debt, and if the economic expansion diminishes, it will adversely affect the debt / deficit balance in China. The Chinese government will have a harder time borrowing money at the same interest rate, and have a harder time paying back debts as the profit from projects diminishes due to the domestic economic slowdown and the global economic recession. Then the government projects will have to face the new consequence of either reduction in size or complete shutdown, and overall investment and financial inflow will diminish, which can be a vicious cycle. Even though Chinese government will put extra effort to prevent such cycle, the diminishing trend is inevitable.

However, It could be a good opportunity for China in terms of restructuring its domestic economic design. Rather than focusing too much on expansion and growth, China can restructure its economy through strengthening small and medium enterprises, or increase the consumers’ purchasing power. The latter might be a harder task for China, as it includes increased welfare, restructuring of wage systems, and implementation of social safe-nets – this is even hard for other developed nations. However, strengthening SMEs is achievable through several banking reforms that would either guide banks to give more access for SMEs to capital, or allow more commercial and private banks to open up and target SMEs as major customers.

China’s Possible Direction

Overall, China is facing a key decision-making period as the U.S. economic power is in question due to the prolonged debt ceiling and budget talks. With strong economic ties to the U.S., China faces trade-offs: whether to continue its economic expansion policies or to restructure its economy. It will be detrimental for China to continue the expansion as there will be no country to be able to support such moves economically. Especially when the world’s number 1 economy is unstable, the scenario is highly unlikely. Hence China will stay low and withhold any further reforms that can tip off the balance. Possible policies could be to strengthen domestic markets, but even then, the implementation of policies will not come fast, as the instability from the U.S. is not predicted beforehand. Nevertheless, this can be the valid option for China at this moment – the restructuring is an inevitable process for a developing nation. 

Cash is always king and no more so than in China. Traditionally a very cash-based market with many High Net Worth Individuals (HNWI) skeptical of having someone else manage their money, wealth management got off to a slow start in China. It started with the establishment of few foreign private banking such as Citi Bank, UBS, and HSBC in China in 2006. In 2007, Bank of China was the first Chinese bank that established a private banking department in Beijing and Shanghai.

Business was slow initially for both foreign and domestic banks. Trust was a key factor – many HNWIs were not comfortable with someone else managing their money, much less a foreign bank, but the sophistication of services offered was also very low. Even today, the private banking business mainly provides consulting services for asset allocation and very little forward planning. Most banks push particular products rather than tailored financial plans that take into account not just a person or family’s financial situation, but their future life events.

Although wealth management is still in a nascent stage, the HNWI population in China has increased dramatically, reaching 700,000 by the end of 2012. In addition, the total AUM in Chinese private banks was 573.6 billion yuan in 2008, but is over 2 trillion yuan today. With this growing trend, we see the huge potential in the wealth management sector in the near future.

China’s large banks also see this opportunity and are focusing more and more on wealth management. The wealth management business does not only bring significant intermediate business income, but also provides an opportunity for organisations to re-structure their retail banking business. This has become especially important as it appears that regulators are finally going to reform interest rates. More flexible interest rates will mean that banks will face increased competition and be able to rely less and less on traditional spread income – this is where higher margin wealth management products and services can help.

Nevertheless, Chinese banks still need a long time to build trust with their customers. In western countries, many private banks already have more than a hundred years of history. Will Chinese banks accomplish the same in less than 90 years?   

Source: Bank Annual Reports, 2013