All Eyes on Europe … While China Quietly Weakens

In recent weeks the crisis in Europe has continued to dominate world markets. But behind the scenes China, the world’s highly touted global growth savior, has been proving more and more fragile.

China continues to try to rein in inflation, recently raising interest rates for the fifth time since last October, but they’ve been unable to get a grip on it. Worse, the aggressive monetary and credit tightening is damaging its economy.

China’s all-important manufacturing sector has weakened sharply, recording its worst reading since February 2009 during the depths of the global financial crisis. Moreover, it’s looking increasingly like China is finally set to begin its own bubble burst.

Especially when you consider this …

Back in late 2008-early 2009, when the global economy was on the edge of the cliff looking down, global governments coordinated unprecedented monetary and fiscal stimulus, backstops and emergency aid to avoid disaster. And even though China was still growing at 6 percent, its government did the same, rolling out the biggest fiscal stimulus package (as a percentage of GDP) in the world — about three times the size of the U.S. fiscal stimulus.

Why did they do it? Jobs.

Experts say China needs to hit a 9 percent growth rate to keep their people employed. Because when unemployment rises, so does social unrest. And that’s the biggest threat to Chinese leadership — a revolution in the most populated country in the world.

Here’s the problem …

Too Much Easy Money!

China’s economy has grown dramatically in the past decade, and it has the largest population in the world. But the economy simply couldn’t absorb all of this easy money! The result: Persistent inflation. And the money ultimately spilled over into speculative assets, both globally and domestically, driving an unprecedented appreciation in Chinese real estate.

For now, the Chinese are trying to engineer a perfect landing, where they put a lid on inflation, without crushing their economic growth — a difficult feat, for sure.

If they can’t, China is on the path of one of two outcomes:

1) An inflationary spiral, or

2) A significant economic slowdown (i.e. recession).

In outcome one, the masses likely rise up against the government because they can no longer afford the basics of life, especially food. In outcome two, the masses likely rise up because of a massive wave of job losses.

Either of these outcomes creates big problems for the global economy — which has relied on Chinese growth to drive global economic recovery.

Unfortunately, for the Chinese government and the global economy …

The Cracks in China
Are Already Showing

Real estate bubbles tend to pop when there are increases in interest rates, downturns in general economic activity, or exhausted demand. I think we can check all three of these. The latter is being self-induced by the government’s attempts to curb both general inflation through interest rates, and property speculation by raising lending standards.

A National Bureau of Economic Research (NBER) study shows the price-to-rent ratio in Beijing so out of line that a stellar yearly price appreciation is required to financially justify buying a property versus renting. If annual home price appreciation slowed to only 4 percent, prospective buyers become financially motivated to turn to renting. And NBER estimated that the demand-hit would likely trigger price declines in Beijing of over 40 percent.

And anytime you have a real estate bubble primed to pop, the next place to look for problems is the banks. In fact, historical financial crises typically find their origin in the property market.

While the Chinese government flooded the country with money back in 2009, it also kept the easy money flowing through cheap loans from state-owned Chinese banks.

Now, China has asked its banks to stress test for a scenario where property prices plunge 50 percent!

A report by Moody’s this week served as a warning on Chinese banks, exposing an extra $540 billion of local government debt, thus adding to the scale of problem loans in the banking system.

Jim Chanos, a well-known China bear and hedge fund manager, has a chart that reveals this overinvestment, not only in Chinese real estate, but Chinese fixed asset investments in general.

Take a look …

From the chart above, as Chanos explains it, never in modern history is there a record of a country that has invested so heavily in fixed assets (greater than 40 percent of GDP) for such a sustained period of time. He estimates that the overbuilding in commercial real estate has been so extreme that there’s a 5×5 cubicle for every man, woman and child in China.

Given this bursting bubble scenario, for a world that has been hitched to the idea that China can grow at a double-digit rate year in and year out, you now have to ask the ultimate question:

What would the global economy look like if China slowed down to 5 percent?

Who gets hurt if China slows? Likely, everyone since the global economy has been reliant on Chinese growth to fuel recovery.

Fitch Ratings reckons that a Chinese slowdown to 5 percent growth would result in a 20 percent plunge in global commodity prices. Indeed a grim outlook for the many emerging market and commodity rich economies that have been huge beneficiaries of China massive stimulus spending in recent years.

On top of that, China as a buyer of the euro, troubled sovereign debt and Greek state-owned assets has been the stabilizing force in European markets throughout the ongoing European sovereign debt crisis.

If this “China-rug” was pulled out from under the global economy, expect another violent, 2008-like, flight from riskier assets.

Bottom line: The world economy remains very interconnected. And the busts associated with the great global credit bubble are still unfolding. Expect crises to ripple. Be defensive!

Regards,

Bryan

P.S. Currencies offer an excellent way to get defensive, because there is always a bull market in at least one currency. To learn how I’m helping my World Currency Trader members stay safe and profit during this global unrest, click here.