The China Conundrum

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Recently, Peter Chiappinelli, portfolio strategist at institutional money manager Grantham Mayo Van Otterloo & Co., stated bluntly that "China is experiencing the mother of all bubbles." Indeed, the investment world has grown increasingly wary of the rapid growth of China and its stratospheric rise, as evidenced by the fact that, in 2011, China-focused funds suffered outflows of $1.2 billion, or 17% of the $7 billion total. This occurred despite the fact that China-focused funds returned an average of 8.8%. In fact, the outflow is extraordinary considering diversified emerging-markets funds were the most popular equity funds in 2011.

Domestic concerns have also been raised about the ability of China to continue down its path of prosperity; in late January, China's national auditor warned of "unignorable" risks in various areas, especially fiscal, financial and state assets management. China's problems can be attributed to the combination of several major factors.

The Inflation Factor
China has recently been struggling with inflation. In January, it experienced a significant jump in inflation to 4.5% in January, a development that has surprised forecasters. Alarmingly, food prices continue to soar in China, rising by 10.5%. Moreover, property prices continue to rise, fueling fears that China may be headed into a real-estate bubble that could negatively impact a global economy already weakened by the European sovereign debt crisis. China is well aware of the potentially disastrous consequences of the popping of its real-estate bubble; several big cities are considering new property taxes while local governments have announced plans to build more low-income housing. Moreover, Chinese bank lending is down 28% in January year-over-year as the Chinese government is expressing reluctance to open the credit valves too quickly for fear of reigniting inflation.

The Lending Factor
This factor is directly related to China's inflationary problems, but it merits its own category due to the degree to which China has extended itself in terms of lending. Since early 2009, Chinese banks and financial institutions have engaged in a record lending spree that has helped back state-owned companies and financed huge infrastructure and property projects. Moreover, the central government has loaned more than $1.7 trillion to provincial and city governments, which in turn have provided stimulus that has fueled increased inflation and a growing real-estate bubble. According to the IMF, the value of loans as a percentage of GDP has doubled in China since 2006. The degree of this lending has worried the investment community, as many of the borrowing entities are in no financial shape to pay back the loans, which are due for repayment in a few years. This in turn, as fellow Seeking Alpha contributor Sy Harding notes, has led to the initiation of programs to exchange the loans for new loans with later repayment dates. Analysts point out that China's lending policies can lead to the likelihood of a sharp rise in non-performing loans, which in turn would adversely affect China's economy.

The Demographic Factor
China is experiencing demographic strains which are putting a damper on prospects of future prosperity. Because of the one-child policy, China has one of the most rapidly aging populations in the world. Moreover, China is experienced a huge exodus from the countryside to the city, one unparalleled in modern history. This exodus in turn has led to skyrocketing food prices and food inflation as well as a societal imbalance that will continue to plague China. China is also suffering from gender imbalance: China now has 32 million more males than females under the age of 20 and the latest figures show that for every 100 girls born in China, 119 boys are born.

The Diplomatic Factor
China has grown increasingly assertive of its power on the international stage; in turn, bilateral relations with the U.S. have become more difficult, especially over areas such as currency manipulation, which the U.S. has repeatedly accused China of doing. China also has clashed with the global community, most recently by siding with Russia in vetoing the U.N. Syrian resolution. China has lashed out at Japan and other countries over maritime boundaries, harshly criticized the selling of weapons to Taiwan by the U.S., and responded with its own version of the Nobel Peace Prize after it was awarded to Chinese dissident Liu Xiabo. These diplomatic conflicts have led to increasing tension, something which is sure to be present as China continues to expand its hegemony.

All of these major factors combine to paint a cautious picture of China's ability to continue roaring down the path of prosperity. A slowdown in growth is being anticipated by many in 2012; Economists on average predicted gross domestic product growth would slow to 8.4% from 2011's 9.2%. Moreover, foreign capital in China fell by 65% in December, another indicator of investor wariness and uncertainty. Keep an eye out for developments in China in 2012. This year could be a pivotal moment for China's economic expansion engine.


Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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