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China's scored plenty of obvious economic successes in the past few years. The Chinese have a bulky currency reserve; they produce and export a surplus of goods; and they have been averaging double-digit GDP growth for several years. These accomplishments have people believing that the good times will keep on rolling -- but I'm not so convinced.
I can't seem to shake one nagging worry about China. Its economy today relies heavily on new fixed investment. Things like new buildings, factories, and equipment account for more than 60% of each year's GDP, or about $3.3 trillion. This has been going on for some time, and China has already used its past investments to build an impressive capacity in a variety of goods. But what will it do for an encore?
The government and its citizens are finding it harder and harder to come up with large sums of adequate new investments. Several commentators have pointed out a few of the more embarrassing results of this increasingly fruitless search. Vitaliy Katsenelson of Investment Management Associates estimates that China's idle steel capacity by itself is greater than the combined production of Japan and South Korea. Time magazine's tour of a multibillion-dollar project to house 1.5 million people found the city empty. And famed short-seller Jim Chanos estimates that China's completing 30 billion square feet of office space right now. Never mind all the existing office space already sitting vacant; that construction alone could put every Chinese man, woman, and child into a five-by-five-foot cubicle. Add to all that China's frenzy to build and buy up homes with no one living in them, and the economic lunacy begins to sound suspiciously familiar.
These aren't trivial sums we're talking about, either. That 30 billion square feet of office space would cost at least $1 trillion in U.S. dollars to build, and crazy schemes like that are actually being listed as contributions to GDP. And that's what's so scary. Fixed investment is typically the most volatile component of GDP, and in China today, there are a lot of reasons to wonder how the country can justify those figures continuing into the future. This slice of the Chinese economy, which accounts for more than half of its GDP, may suddenly see a sharp pullback.
China shakes the world
I believe 2011 will be an inflection point for China. Facing inflation of more than 5% in late 2010, the Chinese central government has had to raise interest rates twice in the last two months. But interest rate hikes have a funny way of exposing bad investments. Those who remember recent U.S. history will remember that a system of gradual interest rate hikes ultimately undid our own housing bubble, sending major ripple effects throughout the world.
The consequences of a Chinese recession would be no less dramatic. Despite its smaller economy, China is a key participant in a number of major markets. The most telling examples are in commodities. Mining companies such as Rio Tinto (NYSE: RIO ) and BHP Billton (NYSE: BHP ) have become incredibly reliant on China, because the country now consumes 58% of the world's iron ore, 33% of its aluminum, and 30% of its annual copper consumption. These materials are used heavily in new construction, and if China slows down, these mining companies will suffer both lower prices and shrinking volumes.
The Asian-Pacific region is also exposed. China accounts for more than 30% of the region's GDP, and the country imports more than $400 billion in goods from its Asian-Pacific partners. In instances like South Korea and Taiwan, exports to China make up 12.4% and 24% of their respective GDPs. A Chinese recession would be debilitating for the region. That would be bad news for investment products tied to those regions, such as the iShares MSCI South Korea ETF and iShares MSCI Taiwan ETF (NYSE: EWT ) . Companies like POSCO (NYSE: PKX ) and Toyota Motors (NYSE: TM ) will also suffer, because of the large amount of business they do in Asia.
Even U.S. and European companies may be at risk. Many businesses have expanded into China in an effort to grow sales. Especially vulnerable are exporters of electrical machinery and power-generation equipment, which account for $360 billion worth of Chinese imports. Industrial stocks like GE (NYSE: GE ) and Siemens (NYSE: SI ) see nearly 15% of their sales go toward Asia, and they will feel an impact if the world's industrial powerhouse undergoes a correction.
The bottom line
A Chinese recession is a credible threat that's not getting its fair share of attention. If it happens, it will reverse several of the high-flying investment themes of the last few years. Commodities, emerging markets, and Chinese stocks would all lose a major support for their current valuations.
Because people have become so accustomed to reports of China's potential, they have left their portfolios exposed to some very real -- and very big -- risks.