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China Shock!

You may say that GDP growing at 7.7% can't be a recession. Well, that's the political number produced by the bureaucrats. Watch the private sector PMI published by HSBC-Markit which I expect to go below 50, indicating "contraction." It is now barely above that.

The China credit crunch once again intensified in January. One big, unidentified entity in January paid the equivalent of 105% interest via a six month repo. To me, this sounds similar to the conditions that allowed Warren Buffet to extract incredible loan terms from the firms he bailed out. How can analysts think that this won't affect China's economy?

Of course, to counter the above scenario, the central China government will accelerate public works projects, building more bridges, highways, low-rent apartments, etc. They will bail out the major banks. They will form "bad banks" that will take over the defaulted loans and then they will allow investment firms to buy into these bad banks. That way, they prevent a chain of bank closures.

But the government probably won't bail out the very large "shadow banking system" that has circumvented banking laws for years. Without that, the great credit boom of the last five years may not have occurred.

Must Read: Chinese Banks, Foreign Markets to Gain From China Lifting IPO Ban

Much of the money in this shadow lending system came from individuals who wanted to earn a higher rate of interest than offered by the banks. Large firms, such as a big ship builder, even invested their operating capital in these in order to get a higher return. Now they can't get their money back, threatening the viability of their firms.

The banks formed "wealth management" entities that took this money and then made loans to small firms, charging interest from 20% to perhaps as much as 130%. Borrowing at those rates practically assures that the company will go broke.

No one knows how large the shadow banking system really is, but estimates are from $6 trillion to $10 trillion. That's huge. Now these loans are experiencing significant defaults. My guess is that perhaps half of those loans will never be repaid. An experience similar to the subprime mortgage avalanche of defaults in the US from 2007 onward is very possible.

The reader may say, "So what, why should I care about what happens in China?" Because a recession in China, which so far has adversely affected luxury retailers including Coach (COH), IBM, U.S. fast food chains such as Yum! Brands (YUM), steel companies, mining equipment firms, etc. will eventually cause ripples throughout Asia, then turning into a potential tsunami. Thereafter, the effects will be felt across the global markets.

Remember, "the Earth is now flat." All countries are dependent on one another.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

Bert Dohmen is founder of the Dohmen Capital Research , now in its 34th year. He also is editor of the acclaimed Wellington Letter, now in its 34th year, and author of the Special Report "The Coming China Crisis" . Dohmen also wrote two books: Prelude to Meltdown (2007) and Financial Apocalypse (2011). He has been rated top MARKET TIMER, including the No. 1 rating (Timers Digest).
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