Walled In: China’s Great Dilemma

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InsightInvestment Management DivisionWalled In:China’s Great DilemmaWe believe China’s debt burden, the inevitable rebalancing of the economy, unfavorable demographics,structural fault lines and the weight of history will bear down on its growth rates.Investment Strategy Group January 2016

Additional Contributorsfrom the InvestmentStrategy Group:Sharmin Mossavar-RahmaniChief Investment OfficerInvestment Strategy GroupGoldman SachsGregory MariaschVice PresidentRobin XingVice PresidentHarm ZebregsVice PresidentAmneh AlQasimiAssociateJiming HaManaging DirectorInvestment Strategy GroupGoldman SachsMaziar MinoviManaging DirectorInvestment Strategy GroupGoldman SachsMatheus DiboVice PresidentInvestment Strategy GroupGoldman SachsThis material represents the views of the Investment Strategy Group inthe Investment Management Division of Goldman Sachs. It is not a productof Goldman Sachs Global Investment Research. The views and opinionsexpressed herein may differ from those expressed by other groups ofGoldman Sachs.

2 01 6 I N S I G H TOverviewConcerns about the slowdown in China’s economy and theChinese government’s tenuous and, many would say, opaquepolicy responses have been the primary driver of the last twosignificant downdrafts in global equity markets. Between August10 and August 27 of 2015, a 21.5% drop in local Chinese equitiesas measured by the CSI 300 Index triggered a 5.5%decline in US equities as measured by the S&P500 Index, an 8.1% drop in non-US developedequities as measured by the MSCI EAFE Index andan 8.4% decline in the MSCI Emerging MarketsIndex. Similarly, in the first two weeks of 2016,China jolted the financial markets with a 16.4%drop in Chinese equities, triggering an 8.0%decline in the S&P 500 Index and an 8.8% and10.7% drop in the MSCI EAFE and MSCI EMindexes, respectively. In both instances, changes tothe mechanism for setting the renminbi exchangerate have created even further uncertainty aboutthe Chinese government’s policy objectives, sincewhat was initially billed as a “one-off” currencychange on August 11, 2015, has morphed into aseries of “one-off” depreciation measures againstthe US dollar. We believe that investors shouldbrace themselves for more of the same.We expect China to remain a significant sourceof volatility in financial markets and commoditydriven economies over the next several years.China faces a great dilemma and has limitedattractive options. It faces the herculean challengeof rebalancing the economy toward consumptionand a more sustainable growth path whileavoiding disorderly and destabilizing adjustments.At a minimum, meeting this challenge requiressuccessful implementation of the reform agenda setout following the Third Plenum of 2013.China is walled in. If the reforms areimplemented too quickly, the country risks a sharpslowdown. If the reforms are implemented tooslowly or not at all, China risks an unsustainableincrease in its debt-to-GDP ratio, which couldpush the country past the tipping point intoInsightInvestment Strategy Groupeconomic and, in all likelihood, political instability.China is also walled in by its deep structuralfault lines, ranging from weak demographics andlow rankings on human capital factors such astertiary education, to low rankings on businessenvironment indicators such as the HeritageFoundation’s Index of Economic Freedom and theWorld Bank’s Ease of Doing Business Index andWorldwide Governance Indicators.China faces these challenges against a backdrop ofslow global growth and an increasing list of countrieswhose own currencies are depreciating against the USdollar. Its leadership must also contend with a UnitedStates that is more vigilant about protecting againstalleged Chinese cyberattacks, promoting a levelplaying field for American companies doing businessin China and pushing back against China’s militaryintentions in the South China Sea.This Insight reviews the current state of China’seconomy and examines the extent of China’simpact on the rest of the world’s economies andfinancial markets. We show that the swings inthe financial markets—particularly in the UnitedStates—are excessive relative to the direct andindirect impact of a slowdown in China. We reviewthe progress—or lack of progress—made to date onthe reform agenda of 2013. We present our short-,intermediate- and long-term economic outlook forChina and conclude with the portfolio implicationsof our views. Our 2013 Insight report, EmergingMarkets: As the Tide Goes Out, contained arecommendation to our clients to reduce theirstrategic asset allocation to emerging market assets.This 2016 Insight report, Walled In: China’s GreatDilemma, recommends a further reduction toemerging market assets.1

2 01 6 I N S I G H TContentsWalled In:China’s Great Dilemma4Walled In: China’s Great Dilemma7China’s Economy: Slowing and SlowlyRebalancing7Quality of GDP Data10 How China Matters to the Rest of the World16 Is China Growing at 3%, 7% or SomewhereIn Between?18 Rebalancing the Chinese Economy21 Identifying the Tipping Point in Chinese Debt24 Walled In: Balancing Reforms with EconomicStability24 A Brief Review of the Reform Agenda26 Taking Stock of the Progress on Reforms26 SOE Reform2Goldman Sachsjanuary 2016

30 Financial Market Liberalization48 Implications of a Large and Growing DebtBurden33 Rural Land Reform and Hukou Reform51 Diminishing Export Competitiveness35 One-Child Policy51 The Weight of History36 Environmental Regulation53 Persistent Structural Fault Lines38 Fiscal Reform55 A Japan-Style Slowdown40 In Summary58 Minimal Impact from New Initiatives40 The Economic Outlook: Short, Intermediateand Long Term59 Investment Implications41 2016 Outlook62 2016 Return Expectations44 2016–20 Outlook62 2016–20 Return Expectations46 Base Case Scenario63 Longer-Term Implications47 Alternative Scenario65 Conclusion47 Longer-Term ProspectsInsightInvestment Strategy Group3

2 01 6 I N S I G H TWalled In:China’s Great DilemmaNot a day goes by without at least one attention-grabbingarticle, if not several, on China. Some are quite alarming. In“The Thucydides Trap: Are the US and China Headed for War?”Graham Allison of Harvard University details how, when a “risingpower” has challenged a “ruling power,” war has resulted in 12 of16 cases over the past 500 years, and warns of a similar outcomebetween the US and China.1 In “The Coming Chinese Crackup,”David Shambaugh of the Brookings Institution argues that Chinais approaching a “breaking point.”2 In “The Great Fall of China,”the Economist suggests that investors are right to be nervous giventhat a slowing China drags down emerging markets, commoditiesand countries such as Germany that have significant exportsto China.3 In “Chinese Domino Effect Still Threatens WorldMarkets,” the Wall Street Journal reports how problems in Chinaare reverberating across the world and affecting the outlook forglobal growth.4 In “China’s Biggest Export Could Be Deflation,”the Financial Times forewarns market participants that China isexporting deflationary pressures across the world.5Admittedly, there has also been a smattering of positivecommentary. Not surprisingly, much of it comes from the Chinesestate-sponsored People’s Daily, China Daily and Xinhua newsagency, but the positive reporting also extends to the West.4Goldman Sachsjanuary 2016

InsightInvestment Strategy Group5

In “False Alarm on a Crisis in China,” longtimeChina observer Nicholas Lardy of the PetersonInstitute for International Economics contendsthat the negative narrative on China is not wellsupported by the facts, and that China is growingat an annual pace of about 7%.6 In “China’sWoes Are Overplayed—It’s an Opportunity,” theFinancial Times advocates that a major inflectionpoint upward is coming.7 And to top off thepositive sentiments, London arranged several daysof pomp and ceremony for President Xi Jinpingin October 2015 to launch what Prime MinisterDavid Cameron has called the “golden era” ofSino-British relations.8The latest economic news out of China—a grossdomestic product (GDP) growth report of 6.9% in2015—has helped fuel the positive sentiments. Yetsuch a report raises more questions than it providesanswers for economists and investors alike.How reliable is the underlying economic data?What is the exact size of China’s foreign exchangereserves? Will the People’s Bank of China (PBOC)devalue the renminbi gradually or will we suddenlywake up to a 15–20% devaluation that willinvariably destabilize developed and emergingfinancial markets? Are the reforms set forth by theThird Plenum of the 18th Central Committee ofthe Communist Party of China (CPC) meeting inNovember 2013 proceeding apace, or are China’sdeep structural fault lines so entrenched thatprogress will be slower than anyone expected?What trade-offs is the CPC leadership preparedto make in the transition from an export-orientedand investment-driven economy to a balanced,consumer-focused economy? At what point willever-increasing debt as a percentage of GDP lead toa credit crisis?The list of questions is a long one, and allpoint to the same dilemma: China is walled in. Ifit rebalances the economy too quickly, China mayface a hard landing. If it opens its capital accounttoo quickly, China may face significant outflowsthat would weaken the currency and destabilize theeconomy. If it embraces reforms too quickly, theCPC leadership may lose control of the economy.If the central government stands behind too muchof the debt issued by local governments and stateowned enterprises (SOEs), it risks engendering abelief that all such debt is “implicitly guaranteed”by the central government.9 If it steps backtoo quickly from such guarantees, the centralgovernment risks introducing more uncertainty intothe financial system and the economy. If China fullyopens its markets to foreign competition, SOEs maysuffer. If it consolidates too many SOEs, absenceof local competition—let alone meaningful foreigncompetition—may compromise quality and reducealready limited efficiency. If China fights corruptiontoo aggressively, there is a risk that governmentofficials and SOE executives will delay decisionsand approvals for fear of making a mistake orbeing caught in a future corruption probe. Hereagain, the list is long. Moreover, as evidenced bythe measures taken to manage the equity andcurrency markets over the last several months,the risk of policy mistakes looms large. Chinafaces these challenges against a backdrop of slowglobal growth and an increasing list of countrieswhose own currencies are depreciating against theUS dollar. Its leadership must also contend with aUnited States that is more vigilant about protectingagainst alleged Chinese cyberattacks, promoting alevel playing field for American companies doingbusiness in China and pushing back against China’smilitary intentions in the South China Sea.This Insight will address these issuesin order to assess their impact on ourclients’ portfolios. We acknowledge“One plus one equals two. But it’s notthat some of the answers are largelyunknowable: Data is limited and of pooralways the case, especially when youquality, and the policy objectives andare talking about local and nationaldecision-making processes of the centraland local governments are somewhatgross domestic product (GDP) dataopaque. Nevertheless, we believe that wein China.”can draw some important conclusionswith respect to China’s short-,—Xinhuaintermediate- and long-term prospectsand any implications thereof.6Goldman Sachsjanuary 2016

We begin with a review of China’s economy,highlighting how China matters to the rest of theworld’s economies and financial markets. We thenrevisit China’s structural fault lines, which werediscussed in our 2013 Insight report, EmergingMarkets: As the Tide Goes Out, to examine anyprogress resulting from the reform agenda of theThird Plenum of 2013. We then present our viewof China’s short-, intermediate- and long-termeconomic outlook. Finally, we conclude with theinvestment implications for our clients’ portfolios.China’s Economy: Slowingand Slowly RebalancingInvestors are concerned about China’seconomy because of its direct impact on theirChinese holdings and non-Chinese holdingsthat have sales and profit exposure to China,as well as its indirect impact on the growthof developed and emerging markets. Worries abouta slowdown in China reverberated throughout thefinancial markets in the summer of 2015 when localChinese stocks nosedived and the PBOC alteredthe renminbi exchange rate fixing mechanism.US equities, for example, dropped nearly 13%in one week. Similarly, in the first two weeks of2016, China jolted global financial markets again,triggering an 8% drop in US equities. We addressthree critical issues affecting our clients’ portfolios: First, we examine the direct and indirectchannels through which China affects the globaleconomy and financial markets. Second, we estimate the degree to which Chinais slowing. Third, we gauge the extent to which China hasrebalanced away from an investment-led andexport-driven economy toward a consumptionfocused economy so it can grow on a moresustainable path.Before we proceed, we provide some context onthe quality of Chinese data.Quality of GDP DataQuestioning the quality of China’s economic datais not new. Since the mid-1990s, Professor HarryXiaoying Wu, currently of Tokyo’s HitotsubashiInsightInvestment Strategy GroupUniversity, has contended that China’s officialGDP data is unreliable.10 In 2007, Premier LiKeqiang, then Communist Party Secretary ofLiaoning province, reportedly said that China’sGDP data is “man-made.”11 This led to the creationof the Li Keqiang Index, composed of electricityconsumption, rail freight volume and bank lending,indicators that Premier Li Keqiang thought were abetter gauge of economic activity. More recently,in 2014, Xinhua News Agency, the official pressagency of the Chinese government, published a“Xinhua Insight” titled “The Enigma of China’sGDP Statistics,” in which it wrote, “one plus oneequals two. But it’s not always the case, especiallywhen you are talking about local and nationalgross domestic product (GDP) data in China.”12The US-China Economic and Security ReviewCommission (USCC), created in 2000 by the USCongress, published an extensive report in 2013on the unreliability of China’s official statistics.13It attributed this unreliability to decentralizeddata gathering, inconsistent quality and methodsacross the country, tax evasion by the private sector(including households and private corporations),and manipulation of data by the central and localgovernments and SOEs.The poor quality of China’s data manifests itselfin several ways; examples include how quicklyGDP data is released and the type of revisions thatfollow, the deviation between aggregated dataand the sum of the underlying components, andthe very low volatility of China’s GDP. We brieflyreview these three examples.China is one of the first countries to report itsGDP, usually about two weeks after the end of eachquarter. This compares with developed economiesthat collect smaller volumes of data more efficientlyand take between four and six weeks. There is alsoa lack of clarity regarding the revisions. Accordingto the USCC, the “revisions are frequent, large,and not always clearly explained.”14 The NationalBureau of Statistics (NBS) of China has revisedupward the real level of 2004 GDP by a whopping16.8% due to greater output from the servicesector.15 Real GDP growth in 2007 has also beenrevised upward to 14.2% from an initial estimateof 11.9%. The revisions in China are systematicallyupward and some are very significant.This is in sharp contrast to the GDP datareleases in the US. The Bureau of EconomicAnalysis (BEA) publishes its advance estimate7

Exhibit 1: Mean Absolute Revisions to US Real GDPGrowthExhibit 2: Difference Between Provincial andNational GDP LevelsRevisions to GDP growth are much smaller in the US than in China.The sum of local GDP levels does not match the nationalreported data.Percentage Points1.4Difference (%)1.21.21.31.150.91.00.80.6100.5Sum of Local GDP Data National Reported GDP Data00.60.4-50.2-100.0Advance toSecondAdvance toThirdAdvance toAdvance to Advance toFirst Annual Second Annual Third AnnualAdvance toLatestBenchmarkRevision-151952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012Note: Based on data between 1992 and 2013.Source: Investment Strategy Group, BEA.Data through 2014.Source: Investment Strategy Group, CEIC, NBS.near the end of the month following the end ofeach quarter. As more data is received, secondand third estimates are released near the end ofthe second and third months, respectively. Finally,quarterly GDP estimates that incorporate annualand comprehensive revisions are released in Julyof each year. A final version published five yearslater incorporates changes in methodology tobetter reflect the evolving US economy. As shownin Exhibit 1, the third quarterly revisions in USGDP data have deviated an average of 0.9% onan absolute basis relative to the first advanceestimate, and the final estimate has deviated anaverage of 1.3% on an absolute basis. The largestabsolute deviation is 4.5%. Most importantly, thesedeviations are both positive and negative and haveaveraged less than 0.1 percentage point in terms oftheir impact on US GDP growth rates.There is also considerable discrepancybetween aggregated data and the data underlyingthe aggregated data in China. One of the mostfrequently used examples is the difference betweenlocal GDP data from China’s 31 provinces andthe national GDP. Since 2003, the sum of theGDP levels reported by the provinces has beenon average 6.1% higher than the national data;in 2012, the sum was nearly 8% higher. ManyChina observers believe that local provinceofficials systematically exaggerate growth tosecure promotions. In fact, a National Bureau ofEconomic Research (NBER) report found thathigher city-level GDP growth has been highlycorrelated with CPC secretarial and mayoralpromotions.16 Tom Orlik, chief Asia economistfor Bloomberg and author of UnderstandingChina’s Economic Indicators, believes that thisoverstatement is a remnant of the1958–61 Great Leap Forward, whenlocal officials exaggerated the harvestto meet Chairman Mao Zedong’s goalof creating an agricultural surplus tofund the industrialization of China.17The USCC points to a popular Chineseidiom, guanchu shuzi, shuzi chuguan,which means “officials falsify economicstatistics because economic statisticsdetermine their achievement, implyingthat manipulating statistics is a customMany China observers believethat local province officialssystematically exaggerate growthto secure promotions.8Goldman Sachsjanuary 2016

dating back to pre-modern China’s mandarinbureaucracy.”18 Exhibit 2 shows the differencebetween the sum of the provincial GDP levels andthe reported national level. Over the entire historyof the data series, the sum of provincial data hasactually been lower than national GDP more oftenthan it has been higher; the Great Leap Forwardera and the post-2003 period are the exceptions.It is likely that statistics are manipulated whenofficials are incentivized. If this is the case, thenincentives to manipulate statistics exist in today’senvironment given the stated goal of doublingChina’s GDP and GDP per capita over 10 years.This goal was first stated by then-President HuJintao in 2012,19 and was most recently reiteratedby both President Xi Jinping20 and Premier LiKeqiang.21 We should note that since 2011, allenterprises have been required to report datadirectly to the NBS via an online system inorder to reduce the impact of local governmentoverstatement of growth. However, this policymeasure has not narrowed the gap between localand national data, as shown in Exhibit 2.A third reason for questioning the quality ofChina’s data is the lower volatility of its GDPrelative to the volatility of other developed andemerging market countries’ GDP, as well asrelative to other measures of economic activity inChina. The volatility of China’s real GDP (detrended to capture economic cycles) is 25% lessthan that of the US, 56% less than that of Japan,and half to one-third that of Asian economiessuch as South Korea and Indonesia. We can alsocompare the volatility of China’s GDP to thevolatility of China’s economic activity indicators.We examined two such measures: the EmergingAdvisors Group (EAG) China Activity Index andthe Goldman Sachs Global Investment Research(GIR) China Current Activity Indicator. The EAGChina Activity Index is a compilation of nearly 50different data series that includes expenditure andincome estimates from households, corporationsand the government sector, as well as directphysical production figures.22 Although the seriesstarts in 1992, EAG believes the data from 2000onward is more reliable. Over the last 16 years, theactivity indicator has both exceeded and laggedChina’s reported GDP, as shown in Exhibit 3. Inaggregate, underlying economic activity based onthis index is 50% more volatile than the reportedreal GDP growth rates. Such lower volatilityInsightInvestment Strategy GroupExhibit 3: Measures of Economic Activity in ChinaAlternative measures of economic activity exhibit morevolatility than China’s reported GDP.% YoY, 3-Month Moving Average181614121086.86.15.264Real GDP GrowthEmerging Advisors Group China Activity IndexGoldman Sachs China Current Activity Indicator2020002002200420062008201020122014Data through Q4 2015.Source: Investment Strategy Group, Emerging Advisors Group, Goldman Sachs Global InvestmentResearch, NBS.compared with that of other countries and relativeto various activity indicators has led most Chinaobservers to conclude that the NBS smooths thereported GDP data.The unreliability of data also applies to otherdata series beyond GDP. For example, DerekScissors of the Heritage Foundation has concludedthat retail sales growth has consistently beenoverestimated, since retail sales have outpacedpersonal income at the same time that personalsavings have increased.23 Higher consumption hasto be funded by either higher income or lowersavings. The USCC similarly points out that retailsales may be overestimating true sales becausethey are based on output by suppliers rather thangoods actually purchased by consumers; retailsales are not adjusted for goods that are “dumpedin warehouses.”24Finally, much of Chinese data is based onproduction—the net output of agriculture, industryand services—while most developed economiesrely more on expenditure-based data. In China, thediscrepancy between the two measures is too widefor either data series to be very reliable. The recentupward revision of coal consumption by a massive17% a year since 2000 illustrates how even a singlecommodity’s production data can be significantlyrevised with no explanation.25 To put this numberin context, the increase in 2012 equates to 70% oftotal US coal consumption annually.9

will not challenge US preeminence in this centuryand is unlikely to escape the “middle-incometrap” (where middle income is defined as GDP percapita between 10% and 40% of US levels basedon Geary-Khamis dollars) over the next decade.However, we have limited confidence regardingwhether actual 2015 real GDP growth was 6.5%,5.5% or even less. We have even less confidenceregarding whether the renminbi will be devaluedby 5%, 10% or 15% by the end of 2016. Suchuncertainty has been factored into our investmentrecommendations. We proceed with caution.Exhibit 4: Chinese Share of Global Demandfor CommoditiesChina accounts for a significant share of demand formany commodities.% of Global Production70Total Chinese Demand60Chinese Net Imports50403020100Iron OreAluminumNickelThermal CoalCopperTinSteel (Crude)ZincLeadCottonCornSoybeansWheatSugarCrude OilNatural Gas (Dry)-10Note: 2015 estimates except for natural gas (2014) and steel (2013).Source: Investment Strategy Group, Bloomberg, British Petroleum, US Energy InformationAdministration, Goldman Sachs Global Investment Research, US Department of Agriculture, WorldBureau of Metals Statistics.There is reason to believe that the quality ofdata coming out of China will improve over time.At the International Monetary Fund’s (IMF’s)annual meetings in Lima, Peru, in October 2015,China announced that it had subscribed to theIMF’s Special Data Dissemination Standard.26 Inthe meantime, however, we remain circumspectabout the quality of its reporting.Given the unreliability of data and limitedtransparency with respect to policy objectivesand decision-making processes, one may wellask how the Investment Strategy Group canprovide investment recommendations withsome degree of confidence. On this topic, we arereminded of our discussion with Pieter Bottelier,senior adjunct professor at Johns HopkinsUniversity’s School of Advanced InternationalStudies and a China scholar: He warned that“anyone who speaks with great certainty[about China] needs their head examined.”27 Weagree. There is a range of confidence intervalsaround all our views. For example, we havegreater confidence that China will maintainreasonable growth over the next year or so.We also have greater confidence that Chinawill not successfully rebalance its economytoward consumption without lowering longterm growth targets. Similarly, we believe China10Goldman Sachsjanuary 2016How China Matters to the Rest of the WorldIn mid-2013, our colleagues in Goldman SachsEquity Research wrote, “China has providedseveral shocks to the world: cheap labor and hencecheap goods, cheap capital via export of excesssavings, and lastly, a massive demand shock forcommodities, particularly basic commodities.”28How the tide has turned. Today, policymakers,economists and investors worry that China is onthe verge of providing a major deflationary shockto the rest of the world. At her September 2015press conference, Federal Reserve Chair JanetYellen referenced “heightened concerns aboutgrowth in China” as one of the reasons for notraising interest rates.29 She expressed concern about

Exhibit 5: Exports to China as a Share of GDPThe impact of a China slowdown on developed and emerging markets has been overstated.% of olombia4Germany3.42.7Emerging Markets (EM)AustraliaJapanSouth KoreaMalaysiaChileThailandPeruPhilippinesEM ex-ChinaSouth AfricaRussiaIndonesiaBrazilIndia0Developed Markets (DM)Data from Q3 2014 through Q2 2015.Note: Based on merchandise exports.Source: Investment Strategy Group, IMF.the spillover effects of slower growth in China torelative to local Chinese demand will have aemerging markets, to Canada as an important USdampening effect on relevant commodity pricestrading partner, and to the US itself.globally, especially when the excess productionLet us examine the salient facts about China’sis exported. Witness the preliminary decision byeconomy to see how its slowdown can affect otherthe US Commerce Department to impose 236%economies and financial markets. We note that thisduties on imports of corrosion-resistant steel fromimpact cannot be measured precisely because dataChina, due to what the US steel industry has calledis not available across all countries and sectors.“illegal and unfair practices.”30 ArcelorMittal’sMost importantly, we cannot, ex ante, know thethird-quarter 2015 earnings report also cited lowimpact of a slowdown in China on risk aversioninternational steel prices “driven by unsustainablyand market sentiment.cheap Chinese exports.”31There is no question that China matters toChina has also been an export market for manythe rest of the world. The question is how muchdeveloped and emerging market countries. Asit matters and whether the volatility in globalshown in Exhibit 5, exports to China account forfinancial markets has been commensurate with the2.3% of developed markets’ GDP; in Australia,direct and indirect economic impact of a slowdown exports to China are much higher, at 5.1% of GDP.in China. China is the second-largest economy inOf Australia’s total merchandise exports, over onethe world, as measured by its GDP of 11.4 trillion. third are exported to China. In the US, exports toIt is the most populous country in the world, withChina account for just 0.7% of GDP. Merchandise1.375 billion people. Most importantly,China accounts for 13% of globalexports and 10% of global imports. Itsdemand accounts for 50–60% of the“Anyone who speaks with greatglobal production of iron ore, nickel,certainty [about China] needs theirthermal coal and aluminum, and ahead examined.”significant share of copper, tin, zinc, steel,cotton and soybeans (see Exhibit 4).—Pieter Bottelier, Senior Adjunct ProfessorWhile its imports of commoditiesat Johns Hopkins Universitymake up a smaller percentage of globalproduction, we believe total demand ismore relevant since excess productionInsightInvestment Strategy Group11

Exhibit 6: Exports to ChinaExhibit 8: Banking Sector ExposuresExposure based on value-added exports is lower than grossexports imply.US and German banks are not meaningfully exposed to China.% of GDPForeign Claims (% of GDP)1645Gross Exports to China1440Value-Added Exports to China3512301025820615410South KoreaChileThailandAustraliaJapanSouth yFranceMexicoUnited KingdomUnited StatesSpain0Turkey50Poland2Loans to China are only a relatively small share of developedmarket banks’ assets.% of Bank lySpainUKData as of Q2 2015.Note: Based on consolidated claims on China on an ultimate risk basis as a share of total assets.Source: Investment Strategy Group, Bank for International Settlements.exports to China also account for 2.3% ofemerging markets’ GDP, reaching as high as 10.3%in South Korea. Of South Korea’s total exports,one-quarter are exported to China. We note that

between the US and China. 1 In “The Coming Chinese Crackup,” David Shambaugh of the Brookings Institution argues that China is approaching a “breaking point.” 2 In “The Great Fall of China,” the Economist suggests that investors are right to be nervous given that a slowing China drags down emerging markets, commodities

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