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China is the world's second-largest economy, a simple fact that underscores the importance of its financial health to investors worldwide.
And unfortunately, thanks to China's subprime crisis, it's not doing as well as we're led to believe.
The Chinese stock market has fallen to levels unseen since the 2009 global financial crisis, and short-term interest rates have reached as high as 25%.
We've been told by the mainstream financial press the Chinese economic crisis is being caused by shadow banking.
The term has been demonized by reporters outside China. But that's not the whole story. In fact, there is a valid reason for shadow banking to thrive in China:
"Chinese banks are mostly state-owned, and they rarely lend money to the private sector. Thus, there has always been strong demand for financing outside of official banking circles," says Money Morning Global Investing & Income Strategist Robert Hsu.
Keep reading to see why it's not shadow banking, but a phenomenon that hits much closer to home for Americans that is the real cause of China's economic woes…
First, you must understand how shadow banking works, because it plays a major supporting role in the real problem.
A state-owned company will borrow from a state-owned bank at the low interest rate set by the government, somewhere around 5%.
"With access to cheap loans, many government entities re-lend money out at higher rates. All-in-all, local governments love shadow banking," according to Robert. "Investors are willing to participate because they believe that the central government will bail them out when the bubble breaks."
Shadow banking is utterly widespread in China right now. It naturally derives from financial repression.
"Shadow banking encompasses everything from private loan sharks to fixed-income investment products sold by banks/insurance companies to the general public," Robert explains.
He points out that shadow banking really took off back in 2009, when the banks were ordered to finance infrastructure and investment spending:
"Local governments, state-owned enterprises and other quasi-government entities then borrowed trillions to build all sorts of projects, creating massive inflation and Yuan devaluation in the process."
Massive inflation and currency devaluation is a shot across the bow to any economy; to the world's second-largest economy, it's a shot heard 'round the globe.
"The significance of shadow banking is that it's China's version of subprime real estate lending, which can blow up and damage the Chinese economy," Robert tells us.
Ventures that look sketchy at 9% interest rates suddenly seem feasible at 5%. Thus, traditional banks steadily lower their lending standards, from prime loans, to subprime, to more and more irresponsible loans.
THAT is the real cause of China's economic problem right now – not shadow banking per se.
Are you thinking back to the U.S., circa 2008 right now? If so, you are dead on.
And here's a scary number:
"The scope of lending is around $5 trillion, larger than the $3 trillion in U.S. subprime debt back in 2008," Robert points out.
But, unlike most of the sensationalist outsider reporting you see on China's economic issues, Robert, an insider who knows how China really works firsthand, isn't freaking out.
First, he doesn't think the impact on the global economy would be absolutely disastrous should China's subprime market burst.
"It's true that any such blow up would be bad for the rest of the world, but because of the Yuan's regulated nature, a fallout would be less global than the European financial crisis."
And second, he believes the Chinese government is "taking the right steps" to crack down on shadow banking, thwarting a subprime burst.
"The new administration in Beijing, already wary of inflation, is reluctant to play along," Robert stresses.
The administration's tightening "credit crunch" is sending a signal to all the players that Beijing will not be there to bail out everyone when the bubble collapses.
It seems to be working, scaring away some of the money.
"Post-crunch, rates spiked up then fell back down, but it is harder now for weaker players to get financing," Robert says.
So, the Chinese government must continue to walk this very fine credit-crunch line. Not enough will fail to thwart rising interest rates; too much will burst the subprime bubble.
Says Robert: "I don't have any easy solution, but it would be a global problem if Beijing fails to handle it properly."
And so investors must sit back, watch, and root for China to maintain its slow climb out of an economic bind.
At least this time for American investors, it feels like a much more comfortable chair than in 2008.
If you're an investor looking for a safe way to navigate China's credit crunch as it ripples through the world's economy, see Money Morning's Global Investing Specialist Martin Hutchinson's picks here.
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