China: It’s the Year of the Draggin’

Today’s investor faces a host of global concerns. Despite a deal brokered in Greece for harsh austerity measures and a steep “haircut” to bondholders, it remains unclear whether the eurozone nation ultimately will avoid default. In the U.S., unemployment remains persistently high, running at over 8% for three years — the longest stretch for jobless rates above that mark since the Great Depression.

But investors shouldn’t take their eyes off of Asia. The problems in China have equally large implications for the global economy. And unlike the European debt crisis and American joblessness, the headlines have been anything but encouraging lately.

China helped power the world through the financial crisis with breakneck growth around 10%. And with forecasts of an 8% increase in GDP for 2012, it’s hardly the end of the world in China.

However, the fact remains that Western companies — and investors — are banking big on China. And as we all know, on Wall Street it’s not necessarily a lack of growth that kills companies, but a failure to live up to expectations.

Here are five reasons China’s Year of the Dragon in 2012 will wind up being the Year of the Draggin’ instead, and how that could wind up hurting unsuspecting investors.

Housing Slowdown

The talk of an overheated housing sector in China are hardly new, so I’ll just share a few of the most recent and dramatic figures:

  • The value of land sales across 130 Chinese cities fell 13% in 2011, according to the China Real Estate Index System.
  • GMO Insights estimates that as much as 14% of China’s GDP growth is a result of “direct” investment in housing. The global investment manager says industry-to-GDP ratio is disturbingly high, approaching the 17% share that technology held of American GDP during the 2000 tech bubble.
  • China’s investment in real estate development rose 28% to almost $1 trillion in 2011 — $200 billion more than U.S. residential real estate investment in 2005, at our housing market peak.

Some folks will say this cooling off is actually due to moves taken by the government to hold back an overheating real estate sector. Beijing recently ordered cities to better manage the supply of land, raise tax rates on the sale of apartments or houses held for less than five years and set price control goals for new homes.

But whether this is a “soft landing” for China housing or indeed a bubble bursting, the bottom line is that the slowing of the real estate industry will naturally weigh on the broader economy there.

Auto Sales

For all the bluster about China’s rapidly growing auto market — the People’s Republic supplanted America as the leader in global vehicle sales back in 2009 — it must be noted that this growth could be running out of gas.

Yes, China’s total auto sales topped 18.5 million in 2011 vs. 12.8 million in America for the same year. But the growth was a meager 2.45% in China for 2011 — compared to a roughly 10% jump in American auto sales. What’s more, U.S. vehicle sales are forecast to grow another 10% to 15% in 2012, while China has another rather anemic growth forecast ahead.

In short, the lion’s share of the auto sales growth in China might already be realized.

Of particular concern is the decline in high-end vehicle sales, with big margins and big profits for manufacturers catering to Chinese elite. Lamborghini recently said sales of ultra-luxury sports cars may slow in 2012. That’s not just a discouraging sign for the auto industry; it could be a hint of future troubles for a host of industries that have relied on China’s free-spending ways — from Macau casino operators like Wynn Resorts (NASDAQ:WYNN) to luxury retailers like Tiffany & Co. (NYSE:TIF).

Manufacturing Slowdown

Beyond the indications for Chinese consumers, the auto industry’s slowdown also is an indicator of trouble on in the mighty manufacturing sector of China.

The closely watched HSBC Purchasing Manager’s Index for China rose in February, but remains at levels that still hint at a modest contraction in the sector. Even worse, underlying data showed a weakening in new export orders — meaning weakness in future readings is likely, too.

Specifically, the flash estimate for HSBC’s February PMI in China was 49.7 on a 100-point scale, up from 48.8 the previous month. Anything less than 50 marks a decline, and anything above 50 signifies growth — so the decent rebound still wasn’t enough to push the index into encouraging territory.

This was despite a positive reading in new orders last month. So it’s very likely to expect a stumble in the HSBC reading next time around now that new orders for February are on the decline. If the PMI report holds, February’s contraction will be the fourth consecutive month of declines.

Foxconn and Worker Unrest

Perhaps even more of a threat to the nation’s economy is a growing backlash from workers in China’s big cities as employees demand better conditions and better pay.

Take the very recent and very public move by Foxconn — a top Apple (NASDAQ:AAPL), Dell (NASDAQ:DELL) and Hewlett-Packard (NYSE:HPQ) supplier — to announce a 25% increase in worker wages. That change, however, amounts to a new monthly paycheck of about $350 for most workers, compared with $286 a month. There also are moves to provide support and better working conditions after a staggering 14 Foxconn workers committed suicide in 2010 alone.

Western media, such as the NPR radio show highlighting “The Agony and The Ecstasy of Steve Jobs,” introduced Americans to the idea of teenagers working up to 16-hour shifts wiping screens or sleeping 15 people to a 12-foot-by-12-foot room.

Chinese media, since it is state-run, obviously has avoided such pieces.

But Foxconn is hardly alone in its efforts to lure cheap migrant laborers to its facilities as a way to keep wages low and margins very high. Workers at an LG Display (NYSE:LPL) factory making flat-screen displays in eastern China recently went on strike to protest similar conditions, halting some production.

In late 2011, Reuters posted a rather stark outlook on worker unrest in China. Here’s a line that sums it up best:

“At factory towns across China’s export powerhouse in the Pearl River Delta, a vicious cycle of slowing orders from the West and increasing wage pressures has led to a series of major strikes that could reverberate through the economy.”

In short, Foxconn’s troubles are representative of a general unrest in China’s manufacturing sector. The country has seen huge growth in the last several years, and many companies have seen huge profits as a result. Unfortunately, that growth frequently has come thanks to workers getting paid rock-bottom wages and working under harsh conditions.

That model is not sustainable. One way or another — either through higher production costs, strikes or shutdowns — Chinese manufacturing is going to have to address these concerns.

‘Shadow Banking’ Threat

According to a study issued by the People’s Bank of China in 2010, non-banking-sector lending expanded to anywhere between $1 trillion and $10 trillion — as much as 40% of the total lending activities of China’s economy. These loans come with exorbitant interest rates as high as 70%. They can come from individuals, akin to loan sharks, but they often come from legitimate businesses, too.

Now this isn’t high-interest lending Atlantic City-style, fueling degenerates who just like to gamble and do drugs. These are investments — loans to start-up businesses or folks looking to buy real estate. In a red-hot economy these arrangements seem like a win-win, with both the lender and the borrower alike coming out ahead.

But what happens when loans can’t be repaid? Unlike banks, which have a large portfolio of loans and assets to fall back on, individuals making these loans don’t have diversified portfolios to protect them. In fact, many lenders may be borrowers, too — creating the risk of a domino effect.

Back in late 2011, I wrote an in-depth analysis of China shadow banking. At the time, China had pledged more oversight of such unregulated transactions. But with growth dependent on easy money and growth harder to come by these days because of the issues previously discussed … well, I have my doubts.

Jeff Reeves is the editor of Write him at, follow him on Twitter via @JeffReevesIP and become a fan of InvestorPlace on Facebook.

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