Cracks In China Economic Foundation, Shanghai Down 5%

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The two main indexes of Chinese stocks, the Hang Seng and Shanghai Composite, have moved almost straight up this year. The Shanghai Composite is higher by more than 80%.

A sharp drop in Shanghai, 5% in one day, is a reminder that the $585 billion stimulus package the central government has put together has become counter-productive and may not work at all if the global economy does not rebound.

China’s GDP expanded more than 7% in the second quarter. Most analysts believe that this is because the large stimulus package flooded the economy with capital. Capital spending, especially spending on infrastructure, helped prop up the industrial portion of China’s expansion. Easy access to credit allowed consumer spending to improve.

The capital from the government was available so quickly that there are now concerns that borrowed money has been used to bid up both the real estate and stock markets. This may have created a sudden bubble in these assets which cannot be maintained if the export portion of economy of the world’s most populous nation does not improve sharply in the second half of the year.

China is faced with the prospect that the economies of the US and EU are still struggling and Chinese exports may not pick up until 2010. The $585 billion may not last long enough to counter falling export activity. The central government could be faced with putting more stimulus money into the economy which may moved prices of real estate even higher.

China has recently warned its banks that their lending is too aggressive, but if they cut back on making capital available, the growth of the economy could be compromised.

China chided the US about its increasing deficit when official from the country visited America this weak. What was left unsaid is that the Chinese have trouble in their own economy, trouble created by government policy, which could hurt China as much long-term as US borrowing will hurt the American recovery.

Douglas A. McIntyre