Why the U.S. needs China

The United States has sneezed. And while it may be too strong to say that China has now caught a cold, it has, at the very least, come down with a bit of a runny nose.

And that's not an encouraging sign for the U.S. economy.

China's government reported on Monday that its economy grew 9% in the third quarter. That is, of course, still robust expansion by any measure.

But it is a cause for concern considering that China's gross domestic product increased at a greater than 10% clip in the first two quarters of this year and has been growing at a double-digit pace annually since 2002.

The Chinese economy was expected to slow a bit following the Olympics in Beijing this past summer. But this is clearly more than a post-Olympic pullback.

It's even more troubling when you take into account the fact that China is a big investor in U.S. stocks and bonds. The Chinese sovereign wealth fund China Investment Corp. has stakes in U.S. financial firms Morgan Stanley (MS, Fortune 500), Visa (V) and Blackstone (BX), for example.
Talkback: Should the U.S. be concerned that China's economy is slowing?

And as I pointed out last week, foreign purchases of U.S. securities - with the notable exception of Treasurys - is starting to slow.

Simply put, a slowing Chinese economy is not good news for the United States. Consider another reason: China is an important customer of U.S. goods.

According to figures from the U.S. Department of Commerce, exports to China increased 18% last year. And China is now the country's third-largest export market. China surpassed Japan in 2007 and trails only Canada and Mexico.

Christian Broda, an economist with Barclays Capital, said in a research report last week that China helped keep the U.S. economy from slipping into a deeper recession in 2001 since it was just beginning to become a more active trading partner with the rest of the world at that time.

China was only added to the World Trade Organization in December 2001.

But Broda pointed out that China's exposure to the global economy is now double what it was in 1998-2002 because of its more active role as an importer and exporter. In other words, it's now too big to be immune from the financial crisis.

"We don't expect China to provide a buffer this time," Broda wrote. "As growth decelerates in the developed world, there is unlikely to be a region in emerging markets that will act as a natural countervailing force."

To be sure, China's economy is not going to grind to a halt. But even a marginal slowdown could hurt large U.S. firms. Many of them have been able to offset sluggish growth in the United States with sales to China and other developing markets.

And it's not certain that China's economy will continue to keep expanding at such a rapid pace in the next few years if this credit crunch continues to persist for much longer.

"This enormous shock to the worldwide banking business, which was really magnified in mid-September, should probably lead to a reduction of 2.5% in the growth for all global economies next year. So if you thought China would grow 10% in 2009, you now have to figure it will grow 7.5%," said Alexander "Sandy" Cutler, CEO of Eaton, a Cleveland -based manufacturer of industrial equipment.

Cutler said he expected China to remain a big growth opportunity for the company. Still, Eaton (ETN, Fortune 500) warned Monday that its fourth-quarter results would be lower than expected in large part due to slowing demand around the globe.

Construction equipment giant Caterpillar (CAT, Fortune 500) also hinted that China's economy would slow down next year when it reported slightly lower-than-expected results for the third quarter Tuesday.

Stuart Hoffman, chief economist of PNC Financial Services in Pittsburgh, said it would not be a surprise if China's slowdown affected other industrial companies, as well as tech firms that have increasingly looked to China as a growth market.

However, he added that there is one piece of good news worth mentioning - China is now the world's second-largest importer of oil. So the sharp decline in crude prices could help keep China spending more than other countries.

And since China doesn't rely as heavily on oil production as other developing nations - Russia being the most notable - it is unlikely to experience as much economic hardship due to falling oil prices.

Still, it's crucial for the health of the U.S. economy that China's doesn't suffer a severe meltdown.

To that end, Treasury Secretary Henry Paulson is giving a speech in New York on Tuesday night about China and the global economy. It will be very interesting to hear what he has to say.

There is already some evidence to suggest that the two nations may need to work together to avert more global economic pain.

When the Fed announced a coordinated interest rate cut on Oct. 8 with banks in Europe and Canada, China's central bank also lowered interest rates that day.

The Fed's announcement didn't mention the Chinese rate cut and China's central bank didn't acknowledge the rate cuts in the United States and Europe. But does anyone honestly think that the United States and China coincidentally decided on the same day to lower interest rates?

Make no mistake. The two countries clearly realize they need each other and that economic hardship suffered by the other is not good for either. China may not have the exact problems that the U.S. does but its third-quarter GDP slowdown is definitely a sign that the credit crunch is hitting China as well.

"This is proof positive that the world is very much interconnected and not decoupled. The U.S. is not the only locomotive for growth. China's growth is likely to continue slowing down," Hoffman said.