Are we putting too much faith in China?
Twenty years ago China was the 10th biggest economy in the world, just behind Brazil. Ten years later it had crept up to number six, slotting in between France and Italy. Today, it is comfortably number two, ahead of Japan but still some way off the United States.
With an average economic growth rate over this period of 10.6 per cent, it is easy to see how China has climbed up the rankings so quickly.
The way investors and economists view China has also changed. It used to be an emerging economy that provided a nice boost to global growth, but it is now a crucial part of the world's economic outlook and one that we depend on to pull us out of the economic doldrums plaguing the Western world.
But are we too reliant on the China story? Is it naive to assume it doesn't really matter what happens in Europe or the United States over the next few years, because we've got China to pick up the slack?
I think China will hold up well over the next few years and that we will see a soft, rather than a hard, landing. In economist-speak, a soft landing means a slowdown in growth, rather than a drastic fall.
Economic growth in China was 10.3 per cent in 2010 and 9.2 per cent in 2011. For the next two years, I'm expecting it to be somewhere between 8 and 8.5 per cent, which is slower than recent years but is still an incredible rate of growth.
But a fall to 5 per cent would constitute a hard landing and it would hurt.
New Zealand and Australia are vulnerable to such a scenario, given China is a key export market for both countries. We export our agricultural products, while Australia sells commodities like coal and iron ore.
China is our second-largest market, taking 12 per cent of our exports. Fonterra sends 9 per cent of its goods to China and in 2010, 31 per cent of its whole-milk powder went there.
Australia is even more exposed. Five years ago China bought 12 per cent of Australia's exports by value, but today it takes a whopping 26 per cent, more than any other country. This indirectly adds to New Zealand's Chinese exposure, because Australia is our biggest export market, taking 23 per cent of our goods.
A recent report from Standard & Poor's estimated that under a hard landing scenario, Australian house prices could fall as much as 20 per cent, severely denting consumer confidence and sending the country into recession.
While the majority of economic forecasters, including Standard & Poor's, which puts the probability of the hard-landing scenario at just 10 per cent, are expecting China to land softly, the risks associated with a more bumpy ride are too big to ignore.
Europe and the US account for close to half of China's exports and Europe, at least, is buying less. Last month, China sold more to the US than to Europe for the first time since 2007. Further weakness in these areas would have a big impact on demand for China's goods, reducing corporate profits and as well as investment spending and consumption.
Fonterra announced earlier in the week that its 2012 payout was likely to be lower than expected, noting the impact that China's reduced growth forecast had on commodity price expectations.
The price for dairy products peaked in November 2007, before falling 56 per cent over the next 15 months in the wake of the global financial crisis and the sharp slowdown in demand that came with it. Our currency fell from US$0.76 to US$0.50 over this same period, significantly softening the blow to our exporters. If China slows markedly and commodity prices suffer, at least our export sector has an important shock absorber in the form of our strong currency.
On the more optimistic side of the argument, there are a number of positive factors that ease some of the concerns around the risks to China's slowing growth.
For a start, the inflation problem that was causing some concern last year has eased. Prices increased 5.4 per cent in 2011 but the annual inflation figure this year is expected to be closer to 3 per cent, partly due to falling food prices. This gives policy-makers a bit of room to ease monetary policy to improve growth, without worrying too much about causing an unwanted inflation spike.
Over the past few months the Chinese Central Bank has achieved this by reducing the reserve requirement ratio (RRR) that it imposes on banks. The RRR is the amount of deposits a bank has to keep in reserve, while the rest can be lent to businesses or customers. Reducing the RRR effectively pushes more money into the economy as it allows banks to lend more.
The property market is another area of concern that may not be as bad as it sounds. Property prices in China have grown at phenomenal rates in recent years, especially in the cities and particularly compared to average incomes. But the Government has taken numerous steps to clamp down on speculation and slow the market down.
Most cities have restrictions on the number of houses a family can own, and the deposit requirements for aspiring homeowners are much more stringent than in the West. Buyers need deposits as high as 30-40 per cent of a home's value and if they are buying a second home, they need an even bigger deposit.
Small businesses also seem to be performing well. One particular small business activity index has risen sharply over the past six months and in February posted the highest reading in two years. This improvement has been driven by falling accounts receivables, lower raw materials costs, increasing profit margins and rising export orders.
When a country has grown as quickly as China has, a slowdown is not only inevitable, it is also necessary to ensure from here growth occurs in a more sustainable way. China has had an internal growth target of 8 per cent since 2005, which it has always beaten. Its current five-year plan (that began last year) aims for a more modest, yet more sustainable 7 per cent.
On balance, I think China will hold up well throughout this year and I believe the longer term growth story remains intact. This will be an important driver of commodity demand for years, which is of huge benefit to Australia and New Zealand.
But in the short-term, growth will slow. Fewer exports to the United States and Europe, a slower property market and the transition of the economy from investment to consumption will ensure this. Investors need to be mindful that while the medium and long term growth path looks rock-solid, there may well be speed bumps along the way.
Mark Lister is head of private wealth research at Craigs Investment Partners. His disclosure statement is available free of charge under his profile on www.craigsip.com. This column is general in nature and should not be regarded as specific investment advice.