Question

Q1 Consider an open economy environment where China suddenly suffers a large collapse in its housing market, so that new investment in China declines very substantially overall. If we view China as a very large component of the “Rest of the World” (especially as regards savings and investment), how would this event affect the “Home Country” which we can take to be the USA?

Answer 1

The high economic growth in China for the last 30 years has been credit-fueled and investment-driven. If China suddenly suffers a large collapse in its housing market, so that new investment in China declines very substantially overall, its growth rate will decline and there could be significant ramifications for foreign trade, financial markets and economic growth in the U.S. and around the world.
The slowing Chinese economy will lead to a loss of confidence in the global markets which could lead to a global financial crisis that would dwarf the one in 2008.

The relationship between the USA and China has been built on extensive trade between the two countries.
Thus following economic effects on US economy could take place:

- Effect on government borrowings: China is the largest foreign holder of U.S. Treasury bills, that is around 19 percent of the public debt held by foreign ountries. As long as China continues to hold a massive amount of forex reserves and U.S. debt, some market observers believe the U.S. economy could be essentially at the mercy of China (if China were to dump their Treasury holdings it could have fearsome implications for the U.S. dollar.)

- Effect on trade: China is the third-largest export market for U.S. goods and the United States is China’s largest export market. China's demand for imports will reduce due to slowdown in the economy which will affect U.S exports.

- Fall in commodity prices: The reduced demand from China will cause a fall in commodity prices, which will threaten the US and the global economy with deflationary pressures.

However, even though the countries of the world are becoming more finacially intertwined, slowdown in China will not pose any real threat to the economy’s long-term prospects.