While a big slowdown would hurt Chinese the most, collateral damage would still be huge

By Dexter Roberts

Moody’s Investors Service, the credit ratings agency, says China has underestimated by half a trillion dollars the exposure of state-owned banks’ loan portfolios to local governments. Despite five interest rate hikes since last October, inflation is now running at 6.4 percent, the fastest since 2008. Second-quarter gross domestic product grew at 9.5 percent, its slowest pace in almost two years.

No one is writing off China. An April Bloomberg survey of economists estimated the economy would grow more than 9 percent this year. The government is flush with cash and ready to prop up key banks and companies in case things get dicey. Yet bearish investors, such as James Chanos of Kynikos Associates, question whether China can beat inflation and stop over-investing in real estate projects and factories without triggering a hard landing. “A lot of people in the broader market are now asking these questions that they weren’t asking before,” says Patrick Chovanec, a business professor at Tsinghua University. “Before, the China story was so powerful that it overcame all doubt. Now there has been a big shift in sentiment.”

If a crash or slowdown occurs—which most analysts define as growth below 7 percent—it will be brought about either by inflation or a reversal in real estate. The Chinese Communist Party is loath to allow high inflation, says Chovanec. In the 1940s, hyperinflation turned ordinary Chinese into Communists. Inflation of around 20 percent was one reason protesters took to Tiananmen Square in 1989. Should inflation exceed 10 percent for long, “they pull a Volcker,” says Chovanec. Paul Volcker, the former U.S. Federal Reserve chairman, defeated high inflation in the U.S. with rates so steep they plunged the country into severe recession.

In real estate, the party has gone on too long. As Nicholas Lardy of the Peterson Institute for International Economics points out, inflation in China is outstripping the one-year savings deposit rate of 3.5 percent. That prompted many Chinese to pour parts of their savings into apartments. Already, 9 percent of economic output comes from residential housing investment. It was 3.4 percent in 2003. With the building boom well under way, supply is finally outstripping demand. The unsold inventory of apartments has gone from zero last summer to about three months’ worth now, according to Standard Chartered Bank.

If apartment prices fall steeply, ordinary Chinese could lose their savings, and local governments will be unable to pay off the loans they took out to invest in residential and commercial projects. Local governments also rely on land sales for over 60 percent of their revenues in some cases, says City University of Hong Kong political scientist Joseph Cheng. In a property bust, few will be buying land. A real estate reversal would drag down local makers of steel, cement, and household furnishings.

Victor Shih, a political scientist at Northwestern University who studies the local debt problem, says the banks are reacting to poor returns on their investments in everything from real estate to subway lines. “Banks’ focus now is to use existing credit to ensure loans don’t go into default,” says Shih. “That makes credit to new projects more difficult—one reason we are seeing a slowdown.”

Moody’s estimates that 8 percent to 12 percent of China’s total loan portfolio could be nonperforming: The official figure is 1.2 percent. Earlier this year, Fitch Ratings warned that nonperforming loans could reach as high as 30 percent. Especially vulnerable are small businesses. They account for 80 percent of employment, according to China’s Ministry of Industry and Information Technology, yet struggle to get credit. “They don’t have adequate liquidity at all,” says Dong Tao, Hong Kong-based chief regional economist at Credit Suisse.

China consumes almost half the world’s production of iron ore, coal, and steel, and 40 percent of its copper. The impact of a slowdown on copper-producing Chile, which ships 23 percent of its exports to China, would be considerable. Samsung, which got 20 percent of its 2010 revenues from China, would sell many fewer televisions and cellphones. Multinationals that make infrastructure equipment would feel the effect. So would Toyota, General Motors, and Volkswagen.

Fitch, which in June published an essay on what slow growth in China would do to the world, says China’s key trading partners in the Asia-Pacific region would be most affected. If China grew only 4 percent in 2012, says the Fitch report, a sharp drop in commodity exports to China would hurt the Australian dollar, which in turn would force interest rates up, which would finally hurt the overheated housing market.

If the Chinese government had to recapitalize its banks and pump up public works, says Fitch Managing Director Tony Stringer, the budget strain might compel the Chinese to buy far fewer U.S. Treasuries. The U.S. would have to offer higher rates on its bonds to attract other buyers, which would drive up the cost of servicing U.S. debt. The U.S., however, would benefit from the drop in commodities prices, especially for oil, as China’s appetite slackens.

The bottom line: A crash would force the Chinese to spend heavily on bailouts and recapitalizations and impact Taiwan, Australia, and Chile severely.

Roberts is Bloomberg Businessweek’s Asia News Editor and China bureau chief.