China Shock!

(Editor's note: This article was submitted on January 22 before the China economic data were released.)

NEW YORK (TheStreet) -- International Business Machines (IBM) came out with a shockingly disappointing earnings report, with sales in China down a whopping 23%. It blames the lack of orders from the large SOEs (state owned enterprises). According to the Wall Street Journal, that consists of a 17% drop in sales of its hardware group last quarter, and "a stunning 40% drop in Chinese hardware sales."

The Wall Street Journal reports that last quarter, sales in its "growth markets" (international) fell 9%. "IBM doesn't think business in China will improve for another quarter or two." Perhaps IBM should be planning on "a year or two."

The China bulls are very much surprised. They shouldn't be if they had been observing the China scene more closely.

Two years ago, I wrote The Coming China Crisis, which was not a popular topic because China was touted as the big growth engine for the world. However, to me the current situation has similarities to 2007 when I cited all the "canaries in the mine" in the U.S. financial markets in my book of that year, Prelude to Meltdown, which predicted a global crisis in 2008. The bulls on Wall Street didn't like that book either because it shattered their bullish story for investors.

In June 2013, when China experienced a severe credit crunch and overnight interest rates soared from 7% to 25% in one day, I warned in our Wellington Letter the invisible, subsurface erosion in China's financial system was emerging. Such a credit crunch does not go away by itself. It sets off a chain of events, shutting off credit to private companies, which then accelerates into an avalanche of loan defaults.

The lack of credit creates a private-sector recession. Money printing usually helps companies with good connections to the government but it doesn't do much for the general economy.

The current China credit crunch is still being denied. The government papered over the aftershock of the June crunch, largely by pushing money into projects that only benefit the big, powerful families controlling the SOEs. Then the government produces some dubious economic statistics showing good growth.

However, the fact is that when lending to private firms stops, the economy stops. The crunch could easily get worse and eventually lead to significant social protests.

The China central government has done its best to "manufacture" positive economic statistics, which we consider largely false. But western economists believe them almost religiously.

The crunch in June 2013 could be for China what the summer of 2007 was in the U.S. when the commercial paper market froze. At the time, I considered the commercial paper event the last piece of evidence that the credit market meltdown had started and would lead to a financial crisis in 2008. That's what propelled me to write the book.

At the time, it was incomprehensible to me that the commercial paper market freeze-up event didn't get much attention. But when major firms like Goldman Sachs (GS), General Electric (GE), Dow Chemical have to go to Warren Buffet for loans because they can't get it anywhere else, it's serious. That's what happened in 2007-2008. Yet, Wall Street stayed bullish, at least in the media, even as the subprime mortgage derivatives melted down.

I see the same thing happening in China now. We started a China newsletter, The China Boom-Bust Analyst, two years ago. But U.S. investors couldn't understand that China was very important to their entire investment portfolio. The IBM story this month probably will soon be forgotten, perhaps in the next 48 hours. But the China recession will worsen.

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.

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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