For nearly two years, economists have warned that China’s economy may soon be hit with a jolt — a jolt that will be felt round the world. Although their concerns have proven unfounded so far, the day of reckoning may finally be at hand.

Why now? A little-noticed editorial in the People’s Daily, the official media outlet of the ruling Communist party, recently hinted at behind-the-scenes concerns that may soon spill into public view. Key policy makers in China appear to be locked in a heated debate, and the outcome could cause a major ripple in the country — and through the rest of the world.
 
First, let me give you a little background…

For the past 10 years, Chinese leaders have made great effort to keep its economy growing at an annual pace of almost 10%. This level has been just high enough to keep a restive population at bay. The vast majority of Chinese citizens have seen their lives improve, but they’ve also seen a rising income gap as the “new” China mints millionaires seemingly every week. But for most Chinese, subsistence living is still the norm.

If the economy cooled from its fast-growth pace, then Chinese planners may have to face increasing social unrest and rising unemployment. This would make the income inequality gap even more glaring. To fuel strong growth, China has encouraged major banks to approve a wide range of loans, most notably in residential construction and public transportation.

Trouble is, these banks are now rumored to be sitting on a whole mess of nonperforming loans. A fast-rising number of empty new apartment buildings dot the landscape, and high-speed trains are largely unused because of steep ticket prices, meaning borrowers don’t have the cash flow to start making loan payments.

How much money are we talking about? China’s National Audit Office notes that borrowing by local governments (which provides funds for housing and infrastructure) now exceeds $1.5 trillion. Private economists peg to $2 trillion. The Audit Office also notes few loans have fallen into the “nonperforming” status, which is simply hard to square with the reality of a rising tide of unoccupied apartment buildings. Private economists suspect the amount of nonperforming loans is large and growing quickly. [Editor’s note: to see evidence of China’s “ghost towns,” do a search on YouTube and see what turns up. Or watch this video here.]

Central planners in Beijing have repeatedly called for a sharp pullback in this kind of lending, though they have done little to actually close the spigot. As noted short-selling guru Jim Chanos, who has been anticipating a collapse in Chinese real estate, recently told India’s NDTV, “They are still going pedal to the metal. They are going full bore at the local level while the central authorities try to restrict growth out of Beijing.”

This is exactly why the recent editorial in the People’s Daily is so intriguing. The newspaper’s editors showed a glimpse of future policy changes when they wrote China can tolerate a “certain degree of economic slowdown” to put the country on a more sustainable growth path. This likely means a much tighter leash on the nation’s banks, which have been largely able to paper over any spike in nonperforming loans by issuing an ever-larger set of new loans.

Don’t let the oblique wording fool you. Tolerating a slowdown is the most direct comment made so far that the Chinese economy needs to get off its too-hot pace. Global market watchers are likely to parse those words evermore carefully in coming weeks and months, perhaps impacting asset prices.
 
China’s policy makers may have little choice but to put on the brakes. Inflation hit a three-year high of 6.5% in June, which puts even greater strain on the banking system. The Chinese government has already increased interest rates on three occasions and, until inflation starts to pull back, more hikes are likely. These hikes could act like a brake on the Chinese economy, pushing growth down toward 5% — or lower — so the economy can be reset for the next expansion phase.

So what does a slowing Chinese economy mean for the rest of us?

Some would feel the pain more than others, starting with Brazil, Australia and Chile — all of which export massive amounts of minerals and fossil fuels to China. Asian neighbors such as South Korea and Japan provide a high level of construction equipment, while Germany has become China’s go-to source for high-tech manufacturing equipment.

Here in the United States, companies aren’t as heavily exposed in terms of exports (though major firms that use Chinese factories would surely feel the pain of rising labor costs if China’s currency strengthens as a result of the government’s economic adjustment steps). U.S. investors would feel the real pain in terms of commodity prices. From iron ore to steel to coal, China’s insatiable demand has pushed up prices across the board. With fewer new apartment buildings getting the green light, demand for these commodities — and their prices — would take a real hit.

Risks to Consider:  China will undergo a transition to new leadership in late 2012 as key positions in the Politburo come up for grabs. China’s current leaders may be ill-inclined to move past the rhetoric phase, simply relying on editorials that constitute desires rather than actions. This would forestall the day when China’s pressures finally take root, as short-seller Jim Chanos and others have been expecting.

Action to Take –> China remains on an unsustainable long-term path because export-led growth and a lack of domestic consumption have put great strains on its currency. The loose banking controls that have enabled a spike in nonperforming loans only increase the pressure. This is likely to lead to an eventual “bursting of the dam” and an economic slowdown.

Japan managed to make a major transition from export-led growth to domestic consumption in the 1970s and 1980s in response to building pressures on its currency. Until China embarks on a similar path, the risk of an economic shock can’t be ignored. If you own mutual funds or exchange-traded funds (ETFs) with a high degree of exposure to these countries, then you may want to book profits.