Why Investors Get So Worked Up About China

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China has been the talk of the markets this week. Monday's news that Chinese banks were facing a cash crunch sent the Shanghai Composite down 5.3% and both European and U.S. markets followed suit. But on Tuesday, China's central bank appeared to shore up some financial institutions with liquidity and both the Dow Jones Industrial Average (DJINDICES: ^DJI  ) and S&P 500 (SNPINDEX: ^GSPC  ) were primed for a recovery. By the end of the week, both the Dow and S&P 500 were up.  

China makes the world go round
The reason markets are so concerned about Chinese banks is the impact the country has on the global economy. While the U.S. has been stuck with anemic growth and Europe has been in a recession, China has been growing at nearly double digits since the financial crisis.  

A liquidity crisis in China right now may look very similar to the one in the U.S. in late 2008. If rates rise too quickly, the housing market could collapse, businesses would stop investing, and growth could quickly turn into contraction. Housing is particularly concerning because many have predicted a bubble in Chinese housing and the government has been taking efforts to curb the rise in home prices. Home prices are up double digits in China over the past year, a rate that's unsustainable long term. The housing boom is like kindling in a financial crisis.

U.S. investors also need to worry about trade. According to the U.S. Census Bureau, the U.S. exported $110.5 billion in goods to China in 2012 and imported another $425.6 billion in goods. The exports fuel U.S. manufacturing plants and the imports make the goods at retail shops affordable. A liquidity crisis could lead to inflation, which would lead to higher prices, which would be both bad for exports and bad for the price of imports.  

Many U.S. companies also produce goods in China. So, falling exports often becomes a negative for U.S. companies, making this a domestic concern.

The silver lining
With every cloud there's a silver lining. A liquidity crisis or a bubble bursting in China could lead to more in-sourcing, or bringing manufacturing back to the U.S. This would disrupt the status quo but long term it could bring jobs back to the U.S.

With wages rising in China and their currency slowly increasing versus the dollar, we're slowly seeing these positive impacts, and an upheaval would hasten the shift.

What to watch in China
Economists have been predicting bubbles in China for the past decade and every once in a while there gets to be real fear one is coming. The challenge for investors is that Chinese state-run banks and other government sources seem to have endless supplies of money, and they're willing to throw it at any problem that arises. Long term that's not a great solution, but over the past few years it's kept China and the global economy churning.

This week's worries are another reason investors should limit their exposure to China. Eventually a bubble will burst there and the growth investors have been chasing will go up in smoke. A diversified portfolio with companies that have a long-term competitive advantage is the best bet in this, or any economy.

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