As residents of the North Bay, we care about consuming locally-produced goods and patronizing our neighbors’ businesses.  Even with our community’s commitment, it seems we are still inundated with goods imported from China.  For most Americans, consuming Chinese-made goods is just part of life.  Does China’s rising prominence threaten our economic well-being? 

China is the second largest economy in the world after the United States as measured by gross domestic product (GDP), the sum of all goods and services produced.  Over the last 30 years, China’s development has been a remarkable story of growth and transformation.  The evolution from a centralized, government-controlled economy to a modern-day capitalist market is far from complete.

For many years, the United States has imported a large amount of goods from China without an offsetting export trade of U.S. produced products.  As a result of this long-standing trade imbalance, China now owns over 23 percent of total U.S. public debt, according to U.S. Treasury data.  This concerns many who believe that China owns enough Treasuries to cause economic harm to the U.S. by selling dollar-denominated securities in a disorderly way.

Is this likely to happen?  I’ll go out on a limb here and say “probably not,” as the intertwining of the U.S. and Chinese economies has created a very complex and delicate relationship.  The United States is an important export market for China, consuming roughly 20 percent of all Chinese production.  Economic theory predicts that the high demand by U.S. consumers would cause the prices of Chinese goods to rise, eventually making those goods too expensive for U.S. consumers.  As a result, consumers would eventually turn to cheaper goods manufactured in the U.S.  Over the past few years, instead of allowing the value of Chinese goods to rise, China has carefully controlled the value of its currency by purchasing vast amounts of dollar-denominated assets. 

This creates an unofficial peg to the U.S. dollar that keeps the value of the Chinese currency on par with the dollar.  By controlling its currency appreciation, China assures that their goods will continue to be attractively priced for U.S. consumers.  This is one of many reasons that we have experienced low levels of inflation in the U.S. economy.             

For China, a rapid sale of dollar-denominated securities is likely to cause more harm than good as an economy that is attempting to emerge from years of state control.  Among the potential outcomes would be a decline in value of China’s remaining U.S. dollar holdings.  A second is that sales would likely precipitate a rise in the value of the Chinese currency that would make exports more expensive to U.S. consumers.  A third and more technical point is that sales of bonds, including U.S. Treasuries, would cause the price of the bonds to decline and interest rates to rise.  Higher interest rates in the U.S. would make it harder for consumers to finance the purchase of Chinese goods.  For these reasons, we believe that China is unlikely to engage in a wide scale sale of U.S. Treasuries anytime soon.

So if we conclude that the U.S. and China will continue to engage in economic detente, what does the future hold for a country that is so dependent on exporting?  According to the World Bank, China’s GDP growth was a remarkable 10.4 percent per year from 1990 to 2010.  The country’s share of world GDP increased from 1.6 to 8.6 percent during that same time period.

This unprecedented rate of growth is unlikely to continue forever.  Growth in more recent quarters, while still in the 8 percent range, is below this 20 year average.  Since the financial crisis, China has experienced a decline in export demand from its most important trading partners, particularly the United States and Eurozone, together accounting for nearly 40 percent of Chinese exports.  Not satisfied with flailing growth, China has engaged in its own version of government stimulus by investing in domestic infrastructure to boost GDP and create jobs within its borders. 

To build infrastructure, China has become a large consumer of foreign-produced goods, particularly commodities and high-tech manufacturing equipment.  It is beneficial that China has become more of an economic partner than a strict exporter on the world stage.  This change is reflected in China’s capital account surplus, the measure of the value of goods exported vs. goods imported.  According to the International Monetary Fund, China’s current account surplus declined from a peak of over 10 percent of GDP in 2007 to an expected 2.3% of GDP for 2012, indicating a significant increase in importation of goods and a declining demand for goods exported to the developed world.  This compares to the United States current account deficit (imports exceed exports) of 3.2 percent of GDP.

A focus on domestic investment is an important step for China but not without its risks.  According to Kenneth Rogoff, Harvard Professor of Economics, investment now constitutes over half of China’s GDP, more than twice the global average.  Some of this investment is believed to be in the fabled “bridge to nowhere,” real estate and infrastructure projects that contribute to current growth statistics but provide no sustainable foundation for the future. 

The path to a capitalist economy in China is likely to be a rough road.  Despite spectacular growth over the past 20 years, per-capita GDP, an important measure of the wealth of a country’s citizens, still ranks 90th in the world.  This is one stark indication of the hard work yet to be done.  The development of a middle class that can afford to consume domestically-produced goods and services reduces reliance on exports and is fundamental for the long-term success of the Chinese economy.  In addition, China continues to face challenges and criticism related to trade protection, environmental concerns, human rights issues and capital constraints.  We are carefully watching the developments in China and considering what it means for our clients not only as investors, but also as consumers who value the opportunity to buy locally. …

Colleen Supran is charted financial analyst and principal at Bingham, Osborn & Scarborough LLC wealth management, 415-781-8535 or www.bosinvest.com.