You're right to worry.

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If China Isn't a Global Risk, What Is?

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The international ratings agency Fitch was downplaying concerns on Thursday that Chinese stocks are a systemic risk to global markets. Many investors, however, are far less sanguine.

Take hedge fund billionaire Paul Singer, who worries Beijing's debt-fueled stock mania could do even more damage than the U.S. subprime crisis. Or Bill Ackman, who runs Pershing Square Capital Management. Asked about Greece on Wednesday, he said: "China is a bigger global threat by far. The Chinese stock market is a fairly remarkable phenomenon and I think kind of a frightening one."

Who's right -- Fitch or market players? The deciding factor could be whether deflation rears its head in China -- falling prices, and the prospect of a slowing national economy, would suggest the hedge funds are right.

Let's consider the data. A common takeaway from China's better-than-expected data this week is that deflation's grip is easing. The claimed 7 percent GDP growth rate, rising middle-class incomes and a pickup in credit would seem to augur well for a stable price outlook in the world's second-biggest economy.

But those numbers are deceiving. For starters, China's second-quarter performance was pumped up by a stock bubble that's now losing air. Financial-sector growth combined with government stimulus (and some creative accounting, of course) to boost gross domestic product. Financial services alone surged 17.4 percent in the first six months of 2015, a dynamic that helped offset a weak real estate market. But, given the recent stock rout that wiped out almost $4 trillion in market value, it should be obvious this isn't a durable source of growth.

Meanwhile, China's housing slowdown is a major deflationary event. Real estate has been China's biggest growth engine since the 2008 global crisis. Now, it's in negative-growth territory. And that's having knock-on effects for local-government finances and vital sectors like manufacturing.

But there's another deflationary force confronting President Xi Jinping: the fading of China's credit super-cycle, in which people and businesses tried to borrow their way out of debt problems. "The world-beating growth in debt of recent years is unlikely to be repeated as worries about financial stability grow," says Andrew Batson, China research director at consulting firm Gavekal Dragonomics. "This creates another barrier to China’s return to rude inflationary health."

Let's say China actually did grow 7 percent between April and June. That's still markedly slower than the 12 percent jump in corporate and household borrowing last month. All that borrowing limits the ability of companies to increase employment and consumers to spend. Outstanding loans for companies and households are now a record 207 percent of GDP (and growing fast), compared with 125 percent in 2008.

While the government is sure to do more to stabilize growth, "we are far from certain that China is about to exit the deflationary dynamic of recent years," Batson says. While China's consumer prices rose 1.4 percent in June, producer prices plunged 4.8 percent.

That dynamic explains why commodity-currency nations Australia and New Zealand are under pressure to slash interest rates. Both the Aussie dollar and the kiwi tumbled to multi-year lows Thursday after fellow commodity exporter Canada eased monetary policy. Meanwhile, waning Chinese demand has resulted in falling global prices for everything from oil to metals to milk. Those problems will be amplified if China begins exporting deflation to the region. Japan, which still has yet to beat its own multi-decade bout with falling prices, is particularly vulnerable, as is South Korea.

The People's Bank of China can always cut interest rates. (Its one-year benchmark rate is still 4.85 percent.) But amid cratering growth, rate cuts might just exacerbate the debt troubles of Asia's only engine of economic growth. In other words, it seems safe to say the hedge fund managers have it right: If China doesn't count as a systemic economic risk, what does?

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author on this story:
Willie Pesek at wpesek@bloomberg.net

To contact the editor on this story:
Cameron Abadi at cabadi2@bloomberg.net