China’s growth in danger of slowing more sharply

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China's cooling economy has already roiled global commodity markets and prompted slowdowns in places such as Latin America, Australia and Germany that had been big beneficiaries of the Chinese boom.

The Chinese economy grew at its slowest pace since the depths of global financial crisis last quarter and is almost certain this year to register its weakest annual growth rate since 1990.

But continued rapid and unsustainable growth in a range of important indicators suggest strongly that China's slowdown has a long way to go before it levels off.

The current deceleration has happened even as credit is still expanding faster than gross domestic product, local governments continue to borrow far more than they can afford and investment in everything from steel production to real estate is rising fast, even as sales slump.

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Given falling demand, the rise in all these indicators is unsustainable and at some point soon they will have to come down, inevitably causing China's growth to slow more sharply.

"I'm confident we won't see a collapse or a financial crisis in China but as credit conditions tighten in the next year or so things are going to get ugly and we will have much less growth," says Jonathan Anderson, president of Emerging Advisors Group, an independent macroeconomic research firm. "What we will inevitably have is a big shakeout on the supply side because that's where all the credit has gone and we may see companies start going bankrupt in droves."

With a 7.3 percent expansion in the third quarter from a year earlier, China still has the fastest-growing big economy in the world but as recently as 2011 it was growing by nearly 10 percent.

As Chinese exports collapsed in the wake of the global financial crisis five years ago, the government launched a credit-fueled investment boom that reignited growth.

Read MoreChina can afford 7% growth rate in 2015: World Bank

In what was intended to be a temporary measure, Beijing lifted controls on credit and flooded the economy with cash, much of which was funneled into an expanding property bubble.

The result was a construction boom and an unprecedented increase in total debt to GDP from 147 per cent at the end of 2008 to 251 percent by the end of June this year, according to estimates from Standard Chartered.

Credit expansion has slowed in recent months but is still growing a lot faster than GDP while providing less and less growth for each renminbi borrowed.

The World Bank alluded to this problem last week when it advised China's rulers to abandon their obsession with trying to hit annual GDP targets (set at "around" 7.5 percent for 2014).

China GDP figures are bogus: Rickards
China GDP figures are bogus: Rickards   

"The current emphasis on meeting short-term growth targets will make it more challenging to implement the policies necessary to shift growth to a more sustainable medium-term path," Karlis Smits, senior economist, wrote in the World Bank China Economic Update, published last week. "Without policy action,the slowdown in China's potential growth in the medium term could be more severe."

Some analysts believe a severe downturn could come sooner.

A slump in property sales and prices that began at the start of this year has been blamed for much of the slowdown in headline growth.

But the correction has so far been fairly mild and has not yet seriously impacted investment and construction, the most important drivers of the Chinese economy.

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The volume of floor space sold in the first nine months of the year was down 8.6 percent from the same period a year earlier.

Meanwhile,the amount of floor space under construction increased by 8.1 per cent in the same period, while newly completed floor space was up 5.1 per cent from a year earlier by the end of September.

This fundamental mismatch in supply and demand is adding to an already huge overhang in the housing market.

In a recent report, Goldman Sachs economists estimate around one-fifth of urban housing in China is empty.

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A range of auxiliary industries, such as steel, face similar fates.

Despite many years of extreme overcapacity and falling profits – the price of steel is now less than the price of cabbage in China – steel production in China was up 5.4 per cent in the first nine months of this year.

Bankruptcies are another area where the pain has not yet really begun.

Han Chuanhua, a bankruptcy lawyer at Zhongzi Law Office in Beijing, says the number of bankruptcies has increased in recent months but many companies that should be going bust are not.

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In many cases this is because local governments simply order courts not to accept bankruptcy cases because they do not want job losses or loss of tax revenue recorded in their jurisdictions.

Many companies have resorted to borrowing at high rates to roll over old loans and keep their gates open for a few months longer.

But as growth inevitably grinds lower in the coming months, most analysts expect to see a lot more failures, particularly in the property sector and upstream industries.

"Real estate developers and steel producers will continue to survive on credit and build up inventories as long as they can because the government can't afford to hurt employment and consumption too much," says Michael Pettis, a professor of finance at Peking University.

"But eventually the government has to allow growth to slow more. The longer growth stays above 5 or 6 percent the worse the debt problem gets and the greater the risk of a really ugly adjustment."