Why China's Economy May Be Heading for a Crash

Empty apartment developments stand in the city of Ordos, Inner Mongolia.
Mark Ralston | AFP | Getty Images
Empty apartment developments stand in the city of Ordos, Inner Mongolia.

China's central bank sent global markets reeling when it attempted tighten credit and rein in the country's shadow banking system. But the consequences of China's credit binge may just be getting started, and experts say there could be more pain to come for the world's second-largest economy.

"We've been seeing tightening since the end of last year," said Leland Miller, China Beige Book International president. "This is not a spur of the moment decision by the central bank."

Leland said the higher interbank lending rates are an indicator of a tension in the system. "The credit transition mechanism is broken and until that's fixed, there will be no happy endings in China," he said.

The People's Bank of China in a statement said the performance of the economy and financial system "are sound" and that there was no shortage of liquidity in the market.

But the economy must still come to grips with the credit binge and the over-investment undertaken in an attempt to avert an economic slowdown at the outset of the global financial crisis.

(Read More: China Is Right to Tame Credit Growth: Moody's)

"They launched $2.5 trillion worth of stimulus in 2008-11," explained Bill Smead, CEO and CIO of Smead Capital Management and a long-term China bear. "Most of that went to special purpose vehicles to build rail, bridges, airports, condo buildings, you name it."

Many of those projects were built with the sole purpose of showing strong economic growth and not to generate economic rent, Smead said.

Gordon Chang, author of "The Coming Collapse of China," said China may only be growing 2 or 3 percent and if you strip out all the construction going into ghost cities and "high-speed rail lines to nowhere," the economy may not be growing at all.

He looks at electricity usage as a better indicator of growth than the official Chinese statistics.

"China claimed 7.7 percent growth for the first quarter," he told CNBC this month. "But when you look at electricity, by far the most reliable economic indicator of Chinese economic activity, that grew 2.9 percent in Q1. When you consider that the growth of GDP is historically 85 percent of the growth of electricity, you're talking 2.5 percent (growth)."

And many of those loans used to finance the construction of those ghost cities and idle train lines may never get repaid. Instead, banks continue to roll over these loans—many made to state-owned companies.

(Read More: Will the Reprieve for China's Lenders Last?)

If the banks were to stop rolling over those bad debts, it could create a capital hole in the banking system and force the government into a costly recapitalization of the banks.

Two things could mitigate the damage, say investing pros—high reserve ratio requirements and China's massive foreign exchange reserves.

David Riedel of Riedel Research Group, told CNBC that while investors need to "worry about the health of the banking sector," the Chinese government's 20 percent reserve requirement for the banks and $3 trillion of foreign exchange reserves are "two strong pillars of support."

But using the foreign exchange reserves to recapitalize the banks could have nasty unintended consequences. Smead said they'd have to convert their U.S. Treasury holdings to yuan and "explosively increase the money supply."

That could torpedo the currency and stoke inflation, Smead said, creating a major crisis.

China Bears

For some international investors, China uncertainty has been reason to avoid the country's equities altogether. Rajiv Jain, manager of the Virtus Foreign Opportunities Fund, told attendees at the Morningstar investment conference earlier in the month that he was "very concerned about the risk coming from China's shadow banking system."

In his first-quarter investment commentary, Jain wrote, "In our view this level of (China) credit growth is unsustainable. There is bound to be a significant contraction in credit and, with it, GDP." He added that the risks are systemic.

That has him thinking defensively about China and investing in companies that do most of their business domestically, Indian banks for instance, and downplaying commodities-related companies that rely on demand from China.

"If a debt-induced economic downturn takes hold in China, it inevitably will have a negative effect on commodity prices as marginal demand slackens or even falls," Jain wrote. "Lower commodity prices would lead to lower income and reduced investment in exporting countries."

Those countries include Indonesia, Malaysia, Brazil, Canada and Australia.

(Read More: Commodities Traders Call End of 'Supercycle')

China Opportunities?

Not everyone shares this pessimism. "We're still of the view that China muddles through," said Todd Henry, emerging markets equity portfolio specialist at T.Rowe Price. "They'll post decent growth, but the trajectory of growth will be lower" as credit growth slows.

That's not a ringing endorsement. Henry acknowledged the misallocation of capital and potential problems lurking in the financial system. But he doesn't see systemic risk.

Richard Gao, a portfolio manager at Matthews Asia, wrote in a note, "We believe that a widespread banking crisis seems unlikely for China, but we have nonetheless taken a cautious approach and typically are underweight in Chinese financials, especially banks, in our portfolios."

Michael Kurtz, global head of equity strategy at Nomura, also told CNBC attempts to rein in credit are "very useful in terms of getting the Chinese economy back on a more sustainable footing as we look out over the medium to long term."

It may even be positive for the country's financial institutions down the line.

"We do think that medium to long term as China begins to actually crack down on the abuses of easy money and begins to apply harder budget constraints at the margin, it could underpin a longer-term re-rating of the sector," Kurtz said. "We're finally starting to see the banks acknowledge the true status of the underlying balance sheets."

T. Rowe is underweight China financials. The stocks are not yet cheap enough to make them comfortable with the risks that may be lurking on their balance sheets, Henry said. T. Rowe prefers the consumer, Internet and environmental themes in China.

BIll Stone of PNC Asset Management also told CNBC that things didn't seem to be falling apart in China and that the recent volatility may be creating future opportunities. "There will be an opportunity in mobile," he said, "Mobile e-commerce in China will certainly be worth watching here going forward."

Is It 2007 or 1979 in China?

Garry Evans, global Head of equity strategy at HSBC, draws the comparison between China in 2013 and the U.S. in 1979 when Fed Chairman Paul Volcker became Fed chairman and took to breaking inflation.

The Chinese government is focused on reform, Evans said. "Markets will want to wait and see whether these reforms happen in China."

T. Rowe's Henry said that Chinese officials' attempts to shift the economy from one driven by government investment to domestic consumption will be a "delicate balance."

"The risk is they don't get this right and it becomes mismanaged," Henry said. "Our view, they've done a good job in terms of managing the economy.

Smead takes a dimmer view, saying China in 2013 is more like the U.S. in 2007-08 when the global financial crisis hit. While he runs a long-only U.S. fund, China is his chief worry and that has him avoiding U.S. energy, resource and industrial companies that depend on China growth.

"It's probably late 2007-08 in China," Smead said. "It's a physical impossibility for economy to be growing as it is" unless credit continues to expand sharply.

He predicts a deep recession or depression that could last four years as it deals with the fallout from the credit binge.

Either way, HSBC's Evans said, "You have to expect Chinese equities to be quite volatile and quite weak."

By CNBC's Justin Menza. Follow him on Twitter @JustinMenza.