Today's market headlines have done a great job explaining proposed changes to China's one-child policy, but they've done little to cover how the country's financial reforms will impact the Dow Jones Industrial Average (DJINDICES:^DJI), the S&P 500 (SNPINDEX:^GSPC), or the U.S. economy as a whole.
In fact, it's reforms to the financial market that may have a lasting impact on the U.S. and drive the Dow and S&P 500 higher in coming years. Here's what we know right now and how it may impact you.
China reforms its finances
China's Communist Party addressed plans for financial reforms in a report released Friday night (China time). Here are the biggest takeaways.
- The Party plans to accelerate interest rate reform, taking rate setting away from a government cap and putting it in the market's hands. Hypothetically, this will result in higher interest rates for household savings and higher rates for businesses.
- The country will "improve" the mechanism for setting the exchange rate. This is murky, but anything that would allow the Chinese renminbi to float more freely on the market would likely be good for the U.S. economy, because it would raise the cost of Chinese-made goods versus U.S. made goods
- Private investors will be allowed to set up banks, taking some of the market away from Chinese state-run banks, which currently dominate lending.
- The bankruptcy system, which is opaque and confusing, will also be reformed. Again, we don't know exactly what that means until rules are written, but if bankruptcy is more of a deterrent than it currently is in China, it will result in a more level playing field with the U.S.
The impact on the U.S. economy
U.S. manufacturing jobs have been going to China for years. One of the drivers has been the low cost of labor there, but maybe more important is the easy money Chinese state-run banks have given to manufacturers.
One reason Apple decided to contract with Foxconn to build the iPhone was that the manufacturer could build out capacity quickly. Normally, a contract manufacturer would have to win a deal before obtaining a loan and building a plant. In China, the promise of bringing thousands of jobs to the country is enough to qualify you for a loan for billions of dollars -- at least it used to be.
This easy money for manufacturing build-out was used by the Chinese solar industry to expand capacity. Suntech Power, LDK Solar (NASDAQOTH:LDKYQ), Yingli Green Energy (NYSE:YGE), and others received tens of billions of dollars in loans just to build solar module capacity in China. In some cases, they didn't even have operations without Chinese bank loans.
Multiply these stories by dozens of industries and hundreds of companies and you have a highly subsidized manufacturing center in China. For now, it appears that the subsidies may be coming to an end.
The impact on U.S. investors
Chinese financial reforms could be a big positive for companies investing in the U.S. Take the solar industry as an example. Chinese manufacturers built capacity so fast in the late 2000s that it crushed the entire industry, bankrupting some of the biggest manufacturers in the U.S. and around the world.
Suntech Power and LDK Solar, two serial borrowers, have missed debt payments this year, yet somehow they're still in business, at least to some extent. If reforms go through, missing debt payments may actually result in bankruptcy, just like it does in the U.S. That would provide at least some downside for companies borrowing from Chinese banks.
If Chinese banks have to begin weighing risk the way U.S. banks do and don't get subsidized rates, and companies' bankruptcy rules are beefed up, we may begin seeing the playing field leveled with China. That's great news for the U.S. economy and companies investing in technology and manufacturing here.
News organizations may not be covering Chinese financial reforms like they are changes to the one-child policy, but that is the big news today. In the long term, this could have a bigger impact on the Dow's and S&P 500's performance than most people think.