HOUSE_OVERSIGHT_014565.jpg

when China’s leadership intervened in the local equity markets and adjusted the trading band around the renminbi, and by 104 basis points in late 2015 and early 2016 when the leadership changed the reference currency from the dollar to a basket of 13 currencies. If US financial conditions had stayed at those levels for over a year, US GDP growth would have slowed by about one percentage point, all else being equal. Financial conditions are the mechanism by which shocks from China would have the most immediate impact on key developed economies such as the US. As mentioned above, one of the triggers of US recessions has been economic imbalances. While we do not see such imbalances in the US, or in other major developed economies, at this time, we see significant imbalances in China. Such imbalances have led to crises in other countries, and there is no reason to believe that they will not lead to a financial crisis in China. In our view, it is not a question of if—it is only a question of when. The biggest imbalance in China is the high level of debt relative to GDP. The Bank for International Settlements (BIS) has a series of early warning indicators. One of the more widely followed and reliable measures is the credit-to-GDP gap, measured as the total credit extended to the private nonfinancial sector as a percentage of GDP compared with its long-term trend. As shown in Exhibit 27, China breached the high-risk threshold in June 2012, when its credit-to-GDP gap rose above the 10% level. At 30.1% as of March 2016 (latest data available) and rising, China’s gap exceeds the 10% threshold by 20 percentage points, levels previously seen in Spain before the European sovereign debt crisis. Major developed and emerging market countries have experienced a financial crisis within three years of their credit-to- GDP gap exceeding 10%. In our 2016 Outlook and our 2016 Insight report, Walled In: China’s Great Dilemma, we stated that we did not expect a hard landing in China over the next two years—2016 and 2017. We continue to assign a low probability to a hard landing in China in 2017. However, it is unlikely that China can avoid a financial crisis over the next three years. In prior years, we have pointed to China’s high savings rate and government control of many aspects of the economy as reasons for its ability to avert a hard landing. However, the country’s debt levels have risen rapidly, the pace of capital outflows has picked up, and net foreign Exhibit 27: Credit-to-GDP Gap Across Economies China’s gap reached the high-risk threshold in June 2012 and has continued to rise. Credit-to-GDP Gap (% of GDP) 50 30 30 High Risk UK Elevated Risk Eurozone 50 US —— Spain Japan China ~~ => Russia 70 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Data through 01 2016. Note: Estimates based on series of total credit to the private nonfinancial sector. Credit-to-GDP gap is defined as the difference between the credit-to-GDP ratio and its long-term trend in percentage points. Long-term trend is calculated using an HP filter. Source: Investment Strategy Group, Bank for International Settlements. direct investment has reversed and is now negative. In our view, neither China’s high savings rate nor its increasing government control of financial markets and capital flows will be sufficient to avert a hard landing over the next several years. Keep in mind that even the US was not able to avert a financial crisis after its credit-to-GDP gap briefly breached the 10% high-risk threshold in December 2006 and peaked at 12.4% in December 2007. The US has the highest GDP per capita of any major country in the world. The large countries that come closest to the US on this score have GDP per capita levels that stand at about 70% of US levels on a nominal basis and slightly higher on a purchasing power parity (PPP) basis. The US dollar is also the unquestioned reserve currency of the world; its reserve-currency status has only been fortified after the Eurozone sovereign debt crisis and the British referendum for Brexit. Thus, the US is able to access the excess savings of the entire world. The US also receives the largest share of world foreign direct investment flows, capturing 14% of global flows between 2011 and 2015. The US now accounts for 20% of the stock of all foreign direct investment. Yet, despite all these major advantages, it did not avert a financial crisis in 2008. It defies logic to assume that China will be the one major country that avoids a financial crisis and a hard landing when it does not enjoy such advantages. As we often say, stating that “this 32 | Goldman Sachs | JANUARY 2017 HOUSE_OVERSIGHT_014565