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I can see a potential perfect storm brewing in China that could -- please note that "could" -- send chaos sweeping over global financial markets and economies.

I can see the conditions for the storm in place -- just as during hurricane season we can see a tropical depression building in the warm waters between Africa and South America. The question now, as with any hurricane, is whether that depression will build into a weak storm -- a Category 1 that lashes countries in its path with rain but doesn't result in much damage -- or escalate to a Category 4 or 5 that leaves a wide swath of destruction in its path.

And, of course, there's the important question of which countries lie in the storm's most likely trajectory.

At this point, I'd say the storm brewing in China is likely to rise to a Category 2 and cause damage to China's economy and stock market, as well as to stock markets and economies dependent on China's economy for growth, including commodity economies such as Australia, Brazil and Canada; Asian trading partners such as South Korea, Malaysia and Indonesia; and global export economies such as Germany.

Beyond that? Well, the timing of this storm adds to the possibility of it rising well above a Category 2, and the vulnerabilities of China's banking system say a Category 3 is well within the odds. For the storm to climb beyond that to the perfect storm level isn't impossible, but given the still rudimentary connections between China's banking system and global financial markets, the global economy would have to be very unlucky for this storm to inflict significant damage on markets and economies outside my list.

Eyeing the weather map

At this point, I'd say cut back on exposure to the markets and economies that are most likely to take a hit from even a Category 2 storm. And watch the weather map carefully to see how the global financial weather develops over the rest of the summer.

image: Jim Jubak

Jim Jubak

The starting point for watching the buildup of China's potential perfect storm is the country's July 15 report that second-quarter GDP came in at 7.5%. First-quarter growth had come in at an annualized 7.7% rate, (barely) above the official government target for the year of 7.5%.

As I've written before, the readings pointed to rough weather ahead. In June, to take one instance, China's exports fell by 3.1% year over year. That was the first drop in exports since the beginning of 2012 and the biggest monthly drop since October 2009.

There are good reasons to believe the data pointing to a slowdown in growth. For example, the European Union, China's biggest trading partner, is in recession. And, most importantly for storm watchers, the People's Bank of China engineered a cash squeeze in China's banking system designed to get credit growth under control.

In the week that ended June 21, the People's Bank produced a liquidity crunch by refusing to inject significant cash into the banking system, sending interbank lending rates (the interest rate that banks charge each other on short-term loans) to double digits. The overnight rate climbed to 28% intraday on June 20. When the bank did start to inject cash into the system, the overnight repurchase rate fell to 5.83% by June 26. But that still left the interbank rate about twice as high as normal. And when the People's Bank did inject cash, it didn't treat all banks equally. Most of the liquidity went to the country's five biggest state-owned banks. Midsize banks still reported a cash crunch.

Engineering a soft landing

This engineered cash crunch is a key source of energy for a developing storm in China.

First, the move makes capital scarcer and more expensive, and that's likely to lower growth in the economy.

Second, while the People's Bank did move to expand liquidity again, it didn't completely reverse its policy. Big banks got cash, and other parts of the financial system were left in a crunch. Since the big state-owned banks lend primarily to big state-owned enterprises, this has left small and midsize companies, which depend on the shadow banking system for capital, facing an extreme cash crunch.

And third, the policy suggests that the government in Beijing might be willing to accept lower growth -- even growth below the target growth rate -- in order to get China's shadow banking sector under control. Fitch Rating's analyst Charlene Chu estimates that a third of all outstanding credit in China is held in channels outside of loans from regulated banks.

The calendar also contributes significantly to the energy driving the development of a storm in China. The second-quarter numbers released July 15, showing that growth had slowed to 7.5%, don't include the entire effect of the ongoing credit crunch. Many of the effects of the June move by the People's Bank are still working their way through the economy, so we still don't know how hard the People's Bank actually stepped on the brake.

For example, we do know that second-tier Chinese banks have faced higher borrowing costs and, as the cost of buying credit default swaps to insure against the chance that loans would go bad have climbed, second-tier Chinese banks have had trouble borrowing funds from Asian banks outside China.

In other words, second-quarter numbers on growth are only the beginning of the story and not the end. Investors, traders and speculators looking at the second-quarter data can't be sure how low growth will go in the next quarter or for the rest of 2013.

Watching China's biggest companies

That doubt has been exacerbated recently by confusing statements by officials ranging from Finance Minister Lou Jiwei to Premier Li Keqiang that mentioned 7% growth as if it might be a new target. Officially, the government's economic growth target for 2013 remains at 7.5%, and China's official Xinhua News Agency corrected Finance Minister Lou's quotation mentioning 7% growth in a July 12 story. But the "accidents" have made markets wonder if the Chinese government is setting up expectations for lower than 7.5% growth -- without a big government effort to stimulate the economy to get growth above target again.

Investors, traders and speculators will be able to get a better read on the dimensions of the China story over the next few months by watching what happens to big Chinese companies that run into trouble.

China faces massive overcapacity in key industrial sectors (China's steel industry is running at just 80% of capacity, for example) that makes it impossible for companies in such sectors as steel, solar, shipbuilding, aluminum and automobiles to make a profit. China Confidential estimates that 75% of the companies in Chinese heavy industries face overcapacity in their sectors. Companies in these sectors survive only because local government officials need the jobs that these state-owned enterprises produce and because they have access to capital from state-owned banks. If state-owned banks stop providing unlimited loans, some companies in these sectors will go belly up (whatever that means in China, since the country does not have a working system for handling formal bankruptcies).

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China Rongsheng Heavy Industries, among China's biggest shipbuilders, is a highly visible test case. Rongsheng is among the roughly one-third of China's 1,600 shipyards with no new orders. The company has 15 billion yuan in loans that come due this year. Net debt is now 168 times shareholder capital. Overdue receivables have climbed by 68 times since 2011. Not surprisingly, the company has applied for government help. The company is theoretically private but Jiangsu province owns a 48% interest. Will Beijing and the province let Rongsheng and its 6,500 jobs go under?

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