While the Dow Jones Industrial Average approaches all time highs, the Chinese stock market is flashing a bright red warning signal about the world economy. Since China is the world’s second largest economy after the United States, a recession in China is almost certain to negatively impact the global economy.
One look at the iShares FTSE/Xinhua China 25 Index (FXI) tells us that investors are extremely pessimistic about the future of China’s economy. Leading up to the financial meltdown of 2008, China was booming based on a massive credit bubble as Chinese banks lent wildly to finance projects regardless of their economic merits. Chinese builders went wild putting up roads that are now empty and cities that are now uninhabited.
The surge in the Chinese economy based on easy credit lead to a parabolic rise in the Chinese stock market which increased by almost 500% from 2005 to 2008. The financial crisis of 2008 resulting in a stock market plunge that erased almost all of the gains from the bubble years.
In order to resuscitate the economy the Chinese government instituted a massive stimulus program that involved government spending and credit extension by the banking system. The total stimulus package amounted to a staggering $1.7 trillion dollars, much of it invested in projects that amounted to building bridges to nowhere. Chinese stocks recovered briefly during 2009 but are now heading straight down again. Now that the spending stimulus is finished, China is left with useless infrastructure such as empty cities and Chinese banks face a mountain of debt defaults as borrowers find themselves unable to repay their debt.
Although there is talk of more stimulus by the Chinese government, banks are no longer willing or able to lend due to the declining value of real estate and other collateral. China is facing the same problem confronting the entire world – slow growth, insolvent banking systems and over indebted consumers and governments.
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