How China can avoid a 2008-like crisis

China is in the acute phase of a deleveraging process that is causing remarkable volatility in the U.S. stock market. China must make hard decisions to avoid crisis and move onto the second, more benign, phase.

China's debt binge has been well documented and now the inevitable deleveraging is occurring. Much like the U.S. in 2008, China now faces tough choices. The political leaders in Beijing must engineer a deleveraging either through recapitalization, currency devaluation, economic growth, or outright default.

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Chinese bank staff member counting stacks of 100-yuan notes at a bank in Huaibei, China.

The probability of outright default is quite low. China has enough resources to absorb much of the bad debt, while default risks political and social unrest. It is doubtful that the Chinese leadership would choose this path. Choosing default, as the solution to its debt problem is a last resort, it's possible but not probable.

The next least likely solution is engineering economic growth. The debt buildup since 2008 created tremendous excess capacity in virtually all economic sectors. Ghost cities and zombie factories are a few of the observable outcomes of this excess capacity. The economic impact of excess capacity is stagnation at best and recession at worst. Therefore, the probability of another China growth miracle is also quite low.

Over the last year, the Chinese government attempted and failed to jump-start its public equity markets. The plan was to fashion a vibrant equity market that debt-laden firms could use to recapitalize via IPOs. The debt burden would have been shifted from corporations to equity holders. Alas, the only thing that Chinese leaders were able to generate was a stock market bubble and subsequent crash. In order to halt the crash, officials were forced to suspend IPO's. In effect, this has eliminated the stock market as an option for any firm looking to recapitalize.

Why China didn't have a choice: Brian Kelly

Currency devaluation is China's last and only realistic choice, in my view. A currency devaluation of 10-15 percent would stimulate export growth and foster inflation that could ease the deleveraging process. Of course a devaluation of this magnitude would send shockwaves through financial markets, but in the medium to long run it appears to be the most probable path.

On the other hand, there is a long-term argument for a stronger currency, especially as China shifts toward consumption. A stronger Chinese currency would give Chinese citizens more purchasing power that could increase consumption of foreign goods. In my view, it is this competing argument that has caused China to commit a monetary policy error.

The competing arguments on the proper direction of the yuan, coupled with capital flight have forced China to defend its currency. By defending its currency, China is actually conducting quantitative tightening (QT) and this contractionary policy has created an ugly deflationary deleveraging that is now washing up on U.S. shores.

The term "ugly deleveraging" was coined by Ray Dalio of Bridgewater and, in my view, accurately describes the current situation. In an ugly deflationary deleveraging, very few asset classes do well, typically commodities and equities fall while bonds rise.

China's yuan could tumble 10% or more

You may be asking yourself why China matters to the U.S. stock market. After all, the U.S. is a relatively closed economy that generally benefits from the deflationary forces currently swirling around the world. China matters to investors because most of the companies in the S&P 500 have growth models that center on China.

In a recent report, Oleg Melentyev of Deutsche Bank, laid out a few stats about the importance of China to the global economy:

• Smartphones: 70 percent of all sales are coming outside of North America and Europe, 45 percent are sold in BRICs countries;
• Big pharma: 43 percent of sales are outside of U.S./EU/Japan;
• Education: Along with travel and thus retail – contributes on quarter to all U.S. services exports, the single-largest line-item; 62 percent of all international students in the U.S. are coming from China;
• Social media: Facebook, Google and Twitter receive about one third of their ad revenue from emerging market countries;
• Media: The movie industry only breaks out international sales, which are 65 percent of the total – but it's reasonable to assume that this being a small-ticket item, the proportion of emerging market sales here could be close to emerging market share of world population, which is 85 percent.

China IS fixing its economy

Most of these goods and services sold internationally do not register as exports from the U.S. as they are assembled/provided, delivered, and booked by non-U.S. subsidiaries of multinational corporations. As an obvious example, if all such revenues were booked as exports, Apple's sales in China alone would account for half of all U.S. exports to that country, services included!

The feedback loop between China and U.S. corporations is stronger than a naive analysis of direct exports would suggest. In the first few weeks of January, U.S. investors have directly experienced the power of this feedback loop.

China is on the verge of its own 2008-like moment, but it does not have to result in a crisis like the U.S. experienced. China has a choice. In the short term, it must abandon its desire for reserve-currency status and its plan to boost consumption through increased purchasing power. These are admirable goals, but China is better suited for them after the deleveraging process.

Chinese market regulators blew it: Bart Chilton

If China does not make the devaluation choice, it risks a crisis that could take years to resolve. During similar experiences, it took the U.S. two years in 2007-2009 and 1930-1932 before it moved to the second stage of the deleveraging. Japan also offers a cautionary example of an economy that prolonged its deleveraging and suffered lost decades.

Until China addresses its debt problem, the global economy will continue to slow and financial markets will continue to remain volatile. There is a path forward, but recent policy mistakes make it unclear if China will choose wisely. As this process unfolds, investors need to exercise extreme caution.

Brian Kelly is founder and managing member of Brian Kelly Capital LLC, a global macro investment firm catering to high net worth individuals, family offices and institutions. He is also the creator of the BKCM Indexes, benchmarks for multi-asset money managers. He's also the author of the upcoming book, "The Bitcoin Big Bang: How Alternative Currencies Are About to Change the World." Kelly, a CNBC contributor, often appears on "Fast Money." Follow him on Twitter @BKBrianKelly.

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