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We already know China is slowing down, because its imports of key commodities have been going down lately, as I summarized in this article. We saw that industrial commodity imports were declining, while gold imports (Figure 1) and U.S. treasury buying (Figure 2) skyrocketed.

Click to enlarge

Figure 1: China Gold Imports from Hong Kong

Figure 2: China U.S. treasury holdings (billion USD)

To avert this slowdown, China has been applying stimulus measures. The consequences can be seen in the weakening yuan (NYSEARCA:CNY) against the U.S. dollar (Chart 1).

Chart 1: USD/CNY

The first stimulus measure was enacted in December 2011. The People's Bank of China said it would cut the reserve requirement ratio by 0.5 percentage point, taking the level to 21% for major banks, effective from 5 December 2011.

In February 2012, China cut reserve requirements again. The People's Bank of China said that it would cut banks' reserve requirement ratio by 0.5 percentage point, effective 24 February 2012. This took the reserve requirements ratio to 20.5%.

And most recently, effective 18 May 2012, China will cut the reserve requirement ratio for banks by 0.5 percentage point to 20%. Deposit reserve ratios are still at a very high level and there is more room to cut. On the interest rate front, China cut its interest rate for the first time since 2008. The one-year benchmark lending interest rate was set to 6.31% (Chart 2). The one-year deposit rate was set to 3.25%, down from 3.5%.

Chart 2: One Year Benchmark Lending Interest Rate China

China is implementing these stimulus measures because it sees that its growth rate is going down. We can see that the downtrend in GDP growth is accelerating (Chart 3).

Chart 3: GDP Annual Growth Rate

I expect even more stimulus measures as China is able to afford stimulating its economy. The inflation rate in China has dropped from a high of 6.5% in August 2011 to 3.4% in May 2012. And this happened while the yuan (exchange rate USD/CNY) appreciated in value from 6.83 to 6.3 against the U.S. dollar (Chart 1) - which worked out to an 8% increase against the U.S. dollar.

Chart 4: China Inflation Rate

We can already see the effect of these stimulus measures in the property market (Chart 5). China wants to support the Chinese real estate market at all costs.

Chart 5: Shanghai Property Index

What China failed to prop up is the Chinese stock market (NYSEARCA:FXI) (Chart 6). The Shanghai Stock Exchange fell from 3150 CNY in 2010 to 2400 CNY currently. This is a drop of 23% and is much larger than the 8% appreciation of the yuan against the U.S. dollar.

Chart 6: Shanghai Stock Exchange

It looks more and more obvious that propping up the economy with stimulus measures isn't working out. In my "Zero Hour" debt article here, I pointed out that additional credit is not adding to GDP anymore in the United States. A similar case can be made for China.

According to the Wall Street Journal money velocity (nominal GDP divided by money supply) is declining in China:

"In 2006, one yuan in credit expansion yielded 0.76 yuan in GDP growth, according to Fitch. In 2007 and 2008, that one yuan of credit continued to create at least 0.70 yuan in growth. But in 2009, as the credit stimulus got under way in earnest, one yuan of new stimulus credit created a paltry 0.18 yuan in additional GDP. That has improved somewhat since then, but for 2011 one yuan of credit still is expected to create only 0.42 yuan in GDP."

Nevertheless, China is continuing its stimulus packages. In the future we can expect a stimulus package of 2 trillion yuan, half the size of the 2008 stimulus package. This stimulus package will be used for investment spending. Additionally, China will keep cutting the bank reserve ratios in the third and fourth quarter, with a possible extra cut in June 2012.

Conclusion

I believe China has enough tools to keep its real estate and stock markets from falling. It will become inflationary in the long run, but with the recent declining Chinese inflation rate in mind, there is a lot of room for additional stimulus.

Investors can react to this scenario by buying commodities. The reason for this is because China is still the largest consumer of commodities and its demand will keep increasing over the years, as China has very little copper, gold, silver, oil, and food stock. Of all these commodities, I recommend investors buy physical silver (NYSEARCA:PSLV) and physical gold (NYSEARCA:PHYS), because industrial commodities will suffer from the current weak global economy.

Source: China's Stimulus Has Only Just Started