How to Digest China's Credit Crunch Cereal

So, you've been consuming large servings of China's "credit crunch" in your morning news lately...but do you know the ingredients hiding inside your breakfast?

Here is a simple breakdown on what China's credit crunch is, and why it's important to your wallet:

Let's begin with some shocking numbers.

China is the world's 2nd largest economy.

The Chinese stock market fell as much as 1.7% on Wednesday, and it had already reached lows unseen since the 2009 global financial crisis.

Short-term inter-bank interest rates last week reached as high as 25%.

It is an understatement to say that investors around the globe are extremely nervous as to what this all means for China's growth.

These dismal numbers all stem from the Chinese credit crunch.

China's government-controlled central bank, the People's Bank of China (PBOC), has been pulling back on feeding the banks yuan to meet the demand for money in order to combat excessive lending that was causing concerns it might overheat the economy and lead to bad investments.

Issues like creating a real estate bubble.

Sound intimately familiar? It definitely should.

Here is what the PBOC is trying to do:

In China, most banks are state-owned, so they can be more closely controlled.

By drying up liquidity, the PBOC effectively cuts off smaller banks from getting a lot of cheap credit.

In turn, that forces the small banks to be more prudent in their lending practices.

And that should halt the real estate bubble.

But it's risky!

As you can see in the shocking numbers above, the PBOC's method drives up short-term interest rates and otherwise adversely affects the market.

In an attempt to quell investor worries, the PBOC, usually extraordinarily tight-lipped, finally released a statement on Tuesday addressing volatility in inter-bank lending rates, declaring it had provided cash to some financial institutions facing temporary shortages and would monitor and maintain stability in the money market.

Goldman Sachs strategists released a report late Tuesday indicating that PBOC's actions will likely only improve the liquidity problem in the short run:

"Tight liquidity conditions may continue for some time, [with] unfavorable funds flow from rising U.S. rates, and investors may hesitate to buy aggressively, given economic uncertainties."

Sounds like many experts believe China is too little, too late in loosening the reins.

And that's a "Big Problem"...

Money Morning's own Chief Investment Strategist Keith Fitz-Gerald recently spoke with Stuart Varney on FOX Business about why it's a "big problem" if China loses control over the situation and can't bounce back:

"China is the world's growth engine when it comes to manufacturing and import/export relationships; so if in fact they're in trouble and if they've got a cash squeeze, that's very significant on a lot of levels because it's going to impact the entire global manufacturing chain. That is the repercussion that's very unsettling to me."

The longer China's credit crunch goes on, the higher the risk that it will feed into the price of credit in the global economy.

Moreover, it's a generally accepted principle that when borrowing costs go up, a company will pass those costs onto the consumer.

And that is scary because in the case of China, *we* are the consumer.

Importing and exporting will take a big hit. Not just between the U.S. and China, but Europe and Japan, two of our biggest trading partners, will also be adversely affected.

If you're an investor looking for a safe way to navigate China's credit crunch ripples in the world economy, Money Morning Global Investing Specialist Martin Hutchinson outlined a good strategy here.

Related Articles: