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Why Chinese Stimulus May Not Be a Good Thing

A few months ago, Chinese Premiere Li Keqiang claimed that the central government would slowly begin a policy of no stimulus. The reasoning behind this policy decision was fairly sound: The economy, though trending strong, was beginning to form a bubble that presaged a rather messy economic meltdown if not deflated. Balance sheets held proportionately large amounts of debt, and reforms were needed to encourage a more hands-off market.

Unfortunately, recent events seemed to be conspiring to prevent these market reforms. Though it is not the only firm to do so, solar and energy development firm Shanghai Chaori Solar Energy Science and Technology defaulted recently on credit bonds, leading to a general fear that a slowing Chinese market could cause ripples in the global economy. 

This, coupled with more conservative growth expectations (currently set at 7.5% growth versys last year's 7.7% expectation), has some economists fearing that China will suffer a wave of credit defaults similar to the Lehman Brothers meltdown several years ago in the U.S. Several economists even contend that it's time for China to reverse its anti-stimulus policies and save its economic gains by propping up ailing industries.

This may be something of an overreaction. China's economy is still strong and has a few things going for it that most people are overlooking.

Defaults, though serious, are proportionately small
While the credit defaults are grabbing the majority of the headlines, the majority of the Chinese economy is still growing. According to former Morgan Stanley economist Andy Xie, only 20% of the economy is slowing. While part of that 20% is composed of high-visibility industries such as steel and technology development, most of China's income sources are growing at a moderate pace. 

China's government can stimulate the economy without a purely fiscal bailout package
China recently announced its intention to speed up infrastructure development, in particular through a sweeping railroad project formerly planned for 2017. By approving the sale of over 150 billion yuan (about $24.2 billion) in credit bonds at favorable rates, the government can nudge investors into domestic projects that will create labor opportunities and make use of underperforming industries (like the steel companies referenced above). These intended railways, designed to bring viable transportation to underdeveloped communities in central and west China, could open up these regions to further infrastructure development and long term growth. 

Tax reforms can help, too
China's recently growing middle class has been investing a lot into small-business development. Unfortunately, more often than not, small businesses are muscled out of market contention by more established firms (that may or may not have state connections and history). While this has occasionally led to defaults, this has also bred a growing disengagement as businesses are unable to attract new revenue streams.

The recent streak of structural tax reform may be the answer to that as well. China is planning to extend lower tax rates for small and medium-sized firms until 2016. While this may not be the panacea that will revive somewhat lackluster middle-class development, it should go a long way toward cushioning smaller businesses as the economy settles into a less explosive state. 

Minimizing American worries
For the time being, U.S. markets need not be worried. If anything, they should be elated that China is forced to support the steel industry, as this gives American firms such as AK Steel (NYSE: AKS  ) the opportunity to compete with (formerly) cheap Chinese steel prices.

This opportunity could not come at a better time for AK and its contemporaries. Despite a strong showing in the second half of 2013, 2014 has been a time of great disappointment for U.S. steel: Stocks have plummeted, in some cases losing as much as 25% of their value. AK itself had managed to almost double its share price across 2013, but it has lost 14% of its value so far in 2014.

While AK is only a single player in the market, China's slight stumble in some areas may give similar U.S. industries some breathing room to recover a stronger relative position.

Slowing down: really not a big deal
Economists are right to note that China is slowing down. Frankly, it was inevitable that this would occur; the U.S. foreign-aid taper notwithstanding, a good number of China's trading partners are in the midst of reworking financial markets in the wake of recent market crises. Without a concurrent slowdown from China, a future bubble (predictable under the circumstances) could have been far more damaging to the world economy.

By making the more conservative decision to engage with the economy through more indirect measures, the Chinese government will ensure that the slowing economy will merely stumble, rather than fall. This will cause slight drops in countries that are highly involved with China, though it's currently hard to tell which countries would be hit the hardest by a slowing Asian market. Potential victims include Mongolia (though the country is making great strides in developing its own economy), as well as Turkmenistan and North Korea (all three derive more than 60% of total trade from China).

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Kurt Avard

A January 2014 addition to the Motley Fool team, Kurt Avard prefers to focus on the "dark" side of business and how it interacts with politics. Rarely writing on the same thing twice, he feels that, if he manages to convince you that the two are inexorably linked, he has adequately done his job. Follow him on Twitter @kurtsavard

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