Our biggest trading partner has a debt problem
China arguably saved the world economy during the global financial crisis by embarking on a massive stimulus programme.
This was exactly what the world needed in 2009, when Chinese GDP grew a staggering 9 per cent. However, the debt-driven growth binge did not stop there. By 2013, China had lifted its debt to GDP by more than 70 per cent of GDP.
Debt accumulation of this scale is rarely well-deployed borrowing. An IMF Article IV assessment of China last year noted that only four countries in the past 50 years had grown their debt at a similar pace - all four episodes ended in a banking crisis.
We think China will prove an exception to this pattern, particularly because most of the lending has been generated internally rather than from overseas lenders. We also see the fresh crop of Chinese leadership as astute managers of the economy, who have so far performed reasonably well in balancing the need for reform against the need to grow.
Nevertheless, at a minimum, New Zealanders should be mindful that the progress China has made in the past five years is unlikely to be a sustainable path for the next five.
Watch the tangled web
If China did have a serious debt-driven slowdown, our direct trade link may be the least of our worries.
Trade does not develop in a vacuum. We have developed a tangled, interrelated web of exposure to China. The most obvious is that Australia, still our second biggest trading partner, is also an economy equally reliant on the fortunes of China.
Therefore, any China slowdown impacts New Zealand indirectly via its impact on Australia (which together with China accounts for 38 per cent of our exports).
Secondly, we need to be mindful of our exposure to Chinese capital flows.
Most of the debate here is around the potential for inbound Chinese investment to skew asset prices (especially in housing).
Whether this is perception over reality is a moot point - data on overseas participation in the real estate market is patchy at best.
However, if we did have a rising exposure to direct Chinese investment it would effectively double down on an already significant trade exposure.
Consider this: what if Chinese consumers needed to reduce their purchases of our goods and repatriate capital from this country at the same time?
That would probably only happen in a Chinese economic crisis. But that is exactly the scenario that would leave New Zealand deeply vulnerable.
An addendum here - an article in last week's Financial Times headlined "Surge in Chinese housebuying spurs global backlash".
Other countries such as Australia, the UK and Singapore have introduced measures to curb foreign house buying. This may be good or bad public policy - but either way New Zealand is impacted.
The harder it becomes to buy property in other countries, the more relatively attractive New Zealand becomes. In other words, lack of a policy is, by default, still a policy.
All of the above begs the question, what does this have to do with building an investment portfolio?
At JBWere, we spend a lot of time thinking about things we hope never happen. Part of building a resilient portfolio is allowing for events that are, by definition, low probability but high impact.
Our thinking on China, and how bad a cold New Zealand catches if China sneezes, is layered into our asset allocation. We lean against an overly concentrated exposure to the Australian and New Zealand sharemarkets - neither offer the geographic or sector diversity that a global portfolio provides.
We also believe a mix of quality local and overseas bonds makes sense. We see too many portfolios in which the "sleep-well" money is made up entirely of New Zealand bonds. That is not prudent diversification.
The rise of China, is, and probably will remain, the most positive development for the New Zealand economy in our lifetime. But for investors and policymakers alike, considering other less fortuitous scenarios is time well spent.
Bernard Doyle is executive director, investment strategy group, at JBWere (NZ).
