China's Economic Slowdown Foreshadows Trouble for the U.S.

China economy
China economy

Industrial activity is down. Retail spending and investment are down. Trade is weaker than expected.

We're talking about China -- the world's once seemingly unstoppable economy. According to official government data released by China last Friday, the turbocharged engine of Asia is starting to sputter and slow down.

Like it or not, the U.S. is inextricably linked to China's success, failure, or stagnation. It's an uneasy relationship, at best.

An Uneasy Alliance

During the Cold War, we used to hear a lot about "mutual assured destruction." This was the idea that both sides knew neither would survive an all-out nuclear confrontation. For that reason, neither would risk launching an attack. So an uneasy status quo, with the U.S. and the Soviet Union perched on the edge of the abyss, held for four decades.

This current, uneasy status quo between the U.S. and China also deserves use of the once-popular acronym for mutual assured destruction: MAD. There's no other way to describe the complicated relationship between the two countries.

The Bank of IOU.S.A.

The U.S. currently has $15.7 trillion in total national debt, and with $1.2 trillion in U.S. bonds, China owns more of it than any other country. But what does that mean, exactly?

Simply put, because our federal government has a difficult time balancing its budget (read: it spends more than it takes in), it issues Treasury bonds to make up the difference. When investors buy Treasuries they're loaning the U.S. government money, and receive interest payments in return. When the bond "matures," they get their full investment back, plus the interest.

Because China produces and sells so much (especially to the U.S.), it needs a place to put the money it earns -- to keep it safe and, ideally, to grow it. You and I put our money in the bank, or invest it in stocks or mutual funds; China invests its money in America by buying Treasuries.

It's safe (the U.S. is unlikely to go bankrupt), and China earns some interest (about 1.84% at the moment). And right now it's China's best investment.

But the relationship doesn't end there.

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We Buy Your Products, You Buy Our Debt. Deal?

Aside from being a safe, interest-bearing place to keep its money, when China buys U.S. Treasuries it props up the value of the dollar. And a strong dollar is good for China because it keeps its currency, the yuan, tied in a tight range to the dollar's value. Consequently, Chinese goods stay cheap to American consumers, which is good for China's economy.

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This is a mutually beneficial relationship, if not a healthy one. Debt like the U.S. is currently carrying is unsustainable, but we're addicted to it, and China is a primary enabler. If we were a eurozone country, the bond markets would be demanding our head on a platter, much as is happening to countries like Greece and Spain.

Because China and others have always been happy to buy our debt, that's never been an issue. But if the Chinese economy continues slowing, and the government in Beijing has less and less money to invest, who's going to fill in the gap?
Until we get our debt down, and start balancing our budgets, this will remain an unsettling question, especially given China's plans to inject some adrenaline into its own economy.

What Happens in China Doesn't Stay in China

To try to turn its economy around, China has taken the step of easing its domestic banks' lending restrictions. This will put more money into the Chinese economy, with the idea that people will spend more and boost the flagging economy.

But more money in circulation can lead to inflation, which could lead to higher prices for many of the products that American companies are having such success selling there.


Widespread Debt: This Is Only The Beginning.


If Apple (AAPL) iPads get too expensive, Starbucks (SBUX) lattes jump too high in price, or Ford (F) cars get too pricey, Chinese consumption of said products will slow down.

As much as you hear that the U.S.-Chinese manufacturing relationship is a one-way street, America actually sells quite a bit to China. Just as with our debt, we need them as much as they need us.

Motley Fool contributor John Grgurich owns no shares in any of the companies mentioned in this column. The Motley Fool owns shares of Apple, Ford Motor, and Starbucks. Motley Fool newsletter services have recommended buying shares of Apple, Ford Motor, and Starbucks. Motley Fool newsletter services have recommended writing covered calls on Starbucks, creating a synthetic long position in Ford Motor, and creating a bull call spread position in Apple.