In a recent post, I discussed how the current slowdown in the Chinese economy posed a near term risk for global financial markets. However, I am now finding myself less concerned as the improvement in recent data along with increasing government support and accelerating growth in bank lending suggests that the economy could be stabilizing.

As seen in the following chart, the HSBC manufacturing PMI registered weak readings earlier this year which was predicted by the drop in new loan growth late last year.

In response, it appears that the Party has again panicked in the face of slowing growth and in recent months has stimulated the economy through tax breaks, investing in railways, rebuilding urban shantytowns, weakening the renminbi, cutting reserve ratio requirements for most banks, relaxing property curbs, and injecting liquidity into the banking system.

These measures have filtered through the economy causing the PMI to strengthen rather than weaken further as indicated by the lending data. In addition, the high rates of credit growth that occurred in the first half of the year are set to bolster the economy during the second half of the year.

Despite the government’s hope to rebalance the economy away from investment driven growth, in recent years whenever investment growth slows as it did during the early part of the year, it causes higher unemployment. Officials recognizing that a large number of people out of the labor force could be a source of social unrest, immediately stimulated the economy with easy monetary policies to increase credit growth and started new investment projects to reignite job growth.

In addition, FT Alphaville recently noted how little we are hearing of Chinese debt defaults despite being in the midst of a wave of distressed corporate loans and wealth management products that are set to come due. FT Alphaville highlights a Credit Suisse note that the likely explanation is that “a combination of bank rollovers, local government bailouts and asset management companies acquisitions has made the distress of trust funds easier to handle in the near term.”

If risks of major corporate defaults and a sharp slowdown in the Chinese economy are taken of the table in the near term, then there is unlikely to be a financial panic occurring this year.

The financial panics that occurred in recent years were due to governments not getting out in front of the problem. In the fall of 2008, it’s unlikely markets would have seized up if the government would have bailed out Lehman Brothers’ creditors as it did with Bear Stearns’ and the Fed cut rates to zero sooner. In 2011, yields on European periphery debt would not have blown out if the ECB had not hiked rates earlier in the year and had not waited until year end introduce the LTRO program.

Technically, Chinese stocks have been strong over the past few months and have recently broken out along with many other emerging markets. This along with depressed valuations and negative investor sentiment could lead to further gains for China’s stock market.

Given that Chinese officials are supporting the economy just when it began to slow, means that China’s Minksy moment has been postponed at the cost of inflating its credit bubble even more. And if there is no hard landing for China in 2014, then global markets should remain resilient and a 15-20% stock market correction is unlikely to occur.

As I explained in a previous post, China has a massive credit bubble that inevitably will deflate. Almost always the onset of debt deflation causes a market panic as disappointed investors run for the exits fearing falling asset prices, bankruptcies, and a sharp economic slowdown.  I believe there is an elevated risk that China could face a Minsky moment in the coming months.

There are several reasons that make me fearful of a China induced market panic this summer. First, new loan growth has been a good leading indicator for economic growth. As shown in the chart below, new loan growth really dropped off in the fourth quarter of last year signalling a deepening economic slowdown in the next few months. Interestingly, new loans picked up significantly in the first quarter, so the economy could experience a temporary rebound in the second half of the year.

Second, China’s property market has cooled considerably in recent months and prices are no longer rising. This is important because property serves as collateral for 20% of all loans. As a consequence, credit growth could slow and non-performing loans at banks could spike higher.

Chinese corporations were already struggling to manage its debts. Currently, more than one-third of China’s GDP is needed just to service the debt.

Third, to make matters worse, a large wave of debt is coming due in the next few months. Though systemically important companies will be bailed out, many others will face default.

As a chilling reminder, the US financial crisis began when the initial wave of mortgage resets hit in early 2008.

The final reason why China could cause a market dislocation during the summer is that Chinese officials seem to recognize the negative effects of the the large scale stimulus implemented in 2009,  and they have openly stated that no large stimulus measures will be forthcoming. Speaking at the annual Boao Forum for Asia on April 10, Premier Li firmly rejected stimulus remedies.

We will not resort to short-term stimulus policies just because of temporary economic fluctuations, and we will pay more attention to sound development in the medium and long run.

I suspect financial conditions will have to get a lot worse before officials backtrack and aggressively stimulate. If so, the following scenario could unfold during the year: economic data from China is reported that badly misses expectations, growth estimates get cut, several companies and wealth management products miss debt repayment deadlines, interest rates fall further on deflationary concerns, the US dollar and Japanese yen surge higher, and stock markets around the world fall by 10%-25% within weeks.

If indeed the Chinese economy disappoints and stocks sell off, I would expect a series of reserve ratio cuts by the PBOC. This monetary easing along with the delayed reaction to the 1st quarter lending surge and mini stimulus announced in April should help the economy to experience a temporary rebound later in the year and halt any market panic.

In the meantime, investors would be wise to raise some cash and hedge their portfolios just in case China causes a temporary panic sell off in global markets.

While China’s economy has slowed down from over 10% in 2010 to 7.4% last quarter, economists unanimously believe growth will soon bottom around 7% and maintain that pace for the next several years. As I will discuss, China’s economy is structured in such a way to make that forecast implausible. More likely, China will continue to decelerate for a few more years after which growth will bottom in the low single digits.

To understand why, it is important to recognize that the high economic growth rate China enjoyed for years was fuelled by a massive credit bubble that is unsustainable and must burst at some point in the next few years. In fact, debt has now grown to a point which has historically tipped countries into painful recessions.

Unlike most western countries, where consumption is the largest source of demand, in China it is fixed asset investment which comprises 50% of the economy and rising. Meanwhile, consumption and net exports are continuing to shrink as a proportion of the economy.

To appreciate the significance of this, imagine if investment stagnates during 2014 while the rest of the economy grows at the same rate as in 2013. Then China’s GDP would drop from 7.7% to 3.8% – a sharp deceleration that most would call a hard landing. Therefore, the only way policymakers can rebalance the economy away from investment and towards more consumption without causing a recession is by having investment growth slow at a gradual pace at the same time consumption growth accelerates.

In practice, there are two reasons why this soft landing handoff between investment and consumption is unlikely. First, real estate investments are an especially important sector of the Chinese economy accounting for one-third of total fixed asset investment and 16% of GDP.

And real estate loans make up 20% of total outstanding loans.

The problem is that home prices, particularly in tier 1 cities,  are among the most expensive in the world relative to peoples incomes.

Also, there has been a significant overbuilding of apartments particularly in lower tier cities leading to inventory that will take years to clear out in a normalized demand environment,

Home prices have risen strongly over the past decade. but an inevitable correction in the property market, which serves as collateral for property loans, would cause widespread defaults, a banking crisis, a plunge in real estate investment, and a hard landing for the economy. In other words, real estate investment will drop significantly during a downturn.

A second reason why investment could fall quickly is that credit bubbles require increasing amounts of credit to create each additional unit of GDP. This is because a lot of the borrowed money is being spent on wasteful projects that do not earn enough of a return to service the debt. This is certainly the case in China where credit growth has been exceeding GDP growth for a number of years. Thus, for China to avoid a sharper slowdown, debt has to keep growing at an accelerating pace.

Unfortunately, 38% of GDP is required to service China’s corporate debt annually signifying that businesses are close to reaching their debt capacity.

And corporations are becoming less productive despite rising leverage.

This trend is not sustainable and in due time should lead to a surge in defaults and nonperforming loans for lenders. The knock on effect is a loss of business confidence leading to declining demand for and supply of credit, and a nasty drop in investment growth.

Most concerning is that China’s economy has already slowed down for three years straight, yet debt-to-GDP has continued to increase. When the economy actually deleverages, growth could decline more meaningfully leading to a financial crisis.

This would be problematic for the rest of the world because China has been the greatest contributor to global growth.

To conclude, I believe the biggest risk investors face in the coming years is a China recession. It will be important to monitor how effective Chinese policymakers will be in stimulating the economy and limiting turmoil in financial markets.

To get a sense of how big China’s current stock market bubble is, I have gathered some facts reported by Bloomberg:

• The Industrial & Commercial Bank of China (ICBC) has a $285.2 billion market value that trails only Exxon Mobil and General Electric. That’s much bigger than Citigroup’s $233.8 billion market cap, despite ICBC’s 2006 earnings of $6.5 billion equal to less than a third of Citigroup’s.
• The CSI 300 Index trades at a PE ratio of 50 compared to the S&P 500’s 17.
• One estimate accounts trading by individual investors for 60% of market volume. In the US, individuals account for only 5% of total trading.
• The CSI 300 has risen 14% since July 23, the day before the credit markets sparked a sell off in global equities. The S&P 500 is down 7% since then.

It is clear that the Chinese stock market is an enormous individual investor driven bubble that makes US stocks looks dirt cheap in comparison. A trade I wish I could make would be to short the CSI 300 and go long the S&P 500. However, this is not possible since the CSI 300 contains yuan-denominated A-shares of companies listed in the Shanghai and Shenzhen exchanges which can’t be traded by foreigners.

One could instead trade the same companies listed in Hong Kong and Singapore, but according to Bloomberg calculations on June 11th, the A-shares are priced at a 54% and 65% discount on the Hong Kong and Singapore exchanges, respectively. This makes the valuation on Chinese shares much less expensive and the trade unattractive.

So while it is obvious that the mainland share prices will eventually crash, it is less obvious how to profit from it. Currently, the only action I can take is to sit back and watch it unfold.

Yesterday, Chinese stocks ignored a rate increase and rose to a record high. It marked the fourth time in a row that Chinese share prices rose on the first day after an interest rate increase. The Chinese authorities are attempting to cool down what is clearly an overheated economy and stock market.

After the 0.27 percentage point increase, a one-year deposit will earn 3.06%, but that interest is taxable, making bank deposits a losing bet in an economy where inflation is reported to be running at 3%. On the other hand, the Shanghai Composite Index has quadrupled in the past two years.

The one-year lending rate was increased by 0.18% to 6.57%, so that the real cost of borrowing is around 3.5%. With the economy expanding at 10% during the last few years there is little wonder why investment activity is so high in China.

China’s fixed exchange rate prevents the government from meaningfully increasing interest rates. Although there are other measures that can be introduced to temper investor enthusiasm such as a capital gains tax, most investors believe that the Chinese government is wary of sparking a crash before the Olympics next year.

Even if the Chinese government does not act to contain the current bubble, a crash could still be triggered by some outside source such as a geopolitical shock. Although I am certain that Chinese stocks are way overvalued, I realize that they can easily become even more overvalued and remain so for a long time. However, the odds of a significant correction or crash are increasing by the day.