Markets Focus on Europe, but China May Be Bigger Worry

China's move this week to keep its economy afloat isn't generating the big headlines that Europe's actions got, but is no less important in keeping the world's economic engine churning.

Great Wall of China photo composite

While coordinated action by the world's other central banks to enhance liquidity for Europe's banks stole the focus Wednesday, China's decision to cut reserve requirements for banks was even more important, some believe.

That's because the developed world has come to depend on China for a variety of reasons — from buying up American debt to providing loans to growing businesses to keeping its mighty manufacturing base growing.

Easing the amount of money banks have to keep on hand, as the People's Bank of China did with a lowering of the rate by half a percentage point, helps accomplish those goals by keeping the lending spigots flowing.

"A change in the reserve requirement literally either frees up or delimits real lending by that nation's banks," hedge fund manager Dennis Gartman told subscribers to The Gartman Letter. "A lowering — or raising — of funding costs is a fly on the mule's skin, but a change in the reserve requirement is a board laid straight away to the mule's forehead."

Worries over China's economic growth have come as a surprise. Whereas the nation actually had been trying to slow down and control inflationthat peaked above 6 percent over the summer, it now finds itself fighting to avoid a slowdown triggered by the European crisis.

Fresh data Thursday showed the Chinese factory sector contracting for the first time in three years, as a purchasing managers' index slipped to 49.0, the lowest since February 2009.

Gartman asserted, then, that the change to the reserve rate requirement in China trumps the decision by six major central banks, including the U.S. Federal Reserve , to cut the interest rate charged for currency swaps. That move essentially lowers the cost of liquidity injections into areas, Europe in particular, that may need it should markets freeze up.

The two moves, though not explicitly coordinated, attack the same problem.

In the case of the PBOC action, the goal is to make sure the nation maintains its ability to grow as it faces a difficult period, inspired mostly by the slowdown in Europe and the corresponding pullback in demand for Chinese products.

The two moves sent U.S. stocks soaring to a 4 percent rally Wednesday, though the momentum appeared short-lived as the market was mixed in Thursday trading. But the entities involved in the two moves are expected to act again in 2012 as policymakers battle the European debt crisis and the corresponding threat of recession.

"We're looking at history being made, history being rewritten, and new theories being created with how to deal with economic crises," said Quincy Krosby, market strategist at Prudential Financial in Newark, N.J. "These are all experiments, whether we're talking about China, Washington, D.C., or Europe."

Indeed, the policymaker reactions make dueling statements about the condition of the economies in question: On one hand, there is little doubt left that central banks are poised to take extraordinary steps to address growth. On the other hand, that aggressiveness signals that the problems are so deep that they will require unprecedented measures to manage.

"The bigger picture is a global response to an economic deterioration in demand," Krosby said. "What investors look at is these moves by central banks offer an opportunity for a major risk-on move."

That could be a mistake, though, if the moves don't have a lasting effect.

David Rosenberg, senior economist and strategist at Gluskin Sheff in Toronto, pointed out that policymakers instituted four such liquidity moves during the financial crisis from 2007 to 2009, resulting in short-term rallies of about 3,000 Dow points. The bluechip average ultimately lost nearly 8,000 points during the downturn.

The short-term effects of such moves had investors worried enough to pull back Thursday.

"We saw ephemeral relief rallies occur during the heart of the 2008 crisis, and while we do not expect conditions to become as dire as they were then, that crisis period is a reminder that even surprising policy action can still wind up being overwhelmed by continued market dislocation," John Shin, forex strategist at Bank of America Merrill Lynch, said in a note to clients.

The China situation is particularly worrisome.

With inflation fears in the background, China now must pivot around and address growth. As such, the PBOC is expected to announce three more reserve rate cuts in the coming months, according to BofAML.

"The Chinese economy is slowing, facing strong headwinds from a worsening European debt crisis," Ting Lu, China economist at BofAML, said in a note. "Export growth could slow significantly from 20 percent in previous months, and falling property prices could affect aggregate demand on the margin."

As such, policy response there will be watched perhaps just as closely as what the European Central Bank, the Fed and the International Monetary Fund try to do with the sovereign debt crisis.

Hopes are that the Chinese authorities have created enough cushion in their inflation fight to provide some policy weapons to get growth going again.

"The PBOC, having embarked on a tightening cycle during the past 18 months, is in a better position to start easing monetary policy, helping to couch business and consumer confidence along the way," Andrew Wilkinson, chief economic strategist at Miller Tabak in New York, told clients. "Nobody wants to see the Chinese PMI repeat its 2008 performance — for everyone's sake."