Economists have spent the last two years warning investors that China's overheating economy may soon be hit with a bucket of cold water.
Even though their concerns have proven unfounded so far, is the day of reckoning finally at hand?
A clue has been found in a mostly overlooked editorial in the People's Daily, the official media outlet of the ruling Communist party. The newspaper's editors wrote that China can tolerate a 'certain degree of economic slowdown' to put the country on a more sustainable growth path.
Don't let the oblique wording fool you. It is the Communist party's most direct comment to-date on the hot Chinese economy. But the piece, largely ignored by the mainstream media, is the biggest hint that the most powerful policy makers in China appear to be locked in an internal debate about conflicting short-term and long-term goals for the world's second-largest economy.
To anticipate the impact of this debate on the global economy, first let me give you a little background.
China's Economic Growth
China is made up of two worlds. For most Chinese, subsistence living is still the norm. The very poor tend to live in the interior of the country, far away from 'new' China's busy (and wealthy) port cities. Even though a vast majority of China's citizens have seen their lives improve in the past decades, they've also noticed a rising income gap between the 'old' and 'new' China.
To keep a restive population at bay, China knows it needs economic growth. So for the past 10 years, Chinese leaders have gone to great lengths to keep the economy growing at an annual pace of almost 10%. If the economy cools, Chinese planners know they will almost certainly face increasing social unrest as millions of unemployed people take to the streets.
China's Money Problem
To fuel strong growth, China has encouraged its major banks to make a wide range of loans, most notably in residential construction and public transportation. How much money are we talking about? China's National Audit Office notes that borrowing by local governments (which provides funds for housing and infrastructure) now exceeds $1.5 trillion. Private economists peg it at $2 trillion.
The trouble is, these banks are now rumored to be sitting on a whole mess of nonperforming loans. Empty new apartment buildings dot the landscape, and high-speed trains are empty because of steep ticket prices. No tenants and no customers mean borrowers don't have the cash flow to make loan payments.
China's Audit Office notes that few loans have fallen into 'nonperforming' status. Private economists, however, suspect the amount of nonperforming loans is large and growing quickly. If you haven't realized it by now, this sounds a lot like the mortgage crisis that precipitated the recent housing boom and bust in America.
Central planners in Beijing have repeatedly called for a sharp pullback in this kind of lending, though they have done little to actually close the spigot. Local officials keep authorizing new loans and spending on projects. This disagreement among policy makers is not normally something that spills out into the open, which is exactly why the recent editorial in the People's Daily is so intriguing.
'The China Shock'
China's policy makers may have little choice but to put on the brakes. Inflation hit a three-year high of 6.5% in June, which puts even greater strain on the banking system. The most common cure for inflation is interest rate hikes because rate hikes act like a brake on an economy.
So what does a slowing Chinese economy mean for the rest of us?
First, any person, company or country exposed to commodities would feel the pain. Brazil, Australia and Chile all export massive amounts of minerals and fossil fuels to China. From iron ore to steel to coal, China's insatiable demand has pushed up prices across the board. With fewer new apartment buildings getting the green light, demand for these commodities -- and their prices -- would take a real hit.
Speaking of infrastructure, China's neighbors, South Korea and Japan, provide much of its construction equipment, while Germany has become China's go-to source for high-tech manufacturing equipment. Fortunately, here in the United States, most companies aren't as heavily exposed in terms of exports to China.
The Investing Answer: China's export-led growth and a lack of domestic consumption have put it on an unsustainable long-term path. High inflation caused by dangerous lending practices is setting up the Chinese economy for a major crisis.
Even though economists have been predicting it for some time, the risk of an economic shock can't be ignored. If you own mutual funds or exchange-traded funds (ETFs) with a high degree of exposure to commodities and/or China-centric companies and countries, then you may want to book profits.
