Is it time to sell China?

For the past few years, China has been the driver of global economic growth. The US is stuck in a weak recovery, Japan has fared even worse, and Europe is stuck in a debt and currency crisis no one envies. Australia has fared better than most, as we supply much of what China needs.

But there are a lot of outstanding questions about China's ability to maintain a stable economy for the long term.

I'm worried that the worst is yet to come for China.

Stimulus that never ends

China has been goosing its economy regularly since 2008. When the financial crisis began to grip the global economy, China announced a $593 billion stimulus package to insulate the Chinese economy from the fallout.

The spending lasted two years and helped China maintain growth throughout the crisis.


China also stimulated the economy through expanded lending at state-owned banks. These banks provide funding for new businesses and businesses looking to expand. They're more focused on maximising employment than on maintaining stringent lending standards.

This year's $164 billion stimulus package is less about a reaction to global events than it is about China's own economy. There was fear that China would grow more slowly than previously anticipated, and if the Chinese economy were to crash-land, it would be devastating to both China and the rest of the world.

But here's the question: When will China's economy stand on its own without the help of government stimulus?

Spending far and wide

The official stimulus funds are just part of the stimulus China gives to its economy. The country's state-owned banks also provide financial stimulus to the economy, and they play a major role in industry.

In the solar industry alone, the China Development Bank granted solar and wind companies up to $47 billion of loans in 2010, boosting production of both renewable energy sources. These were essentially lines of credit given to companies that never would have qualified for such funding in other countries. The funds were used to build out capacity in wind and solar, which left both industries oversupplied. Profits for the companies that received credit dried up, and there's little possibility these loans will ever be repaid in full. This is just one example, but you can see this sort of stimulus in industries throughout China.

China isn't yet rampant with bankruptcies from companies or projects that should never have been built in the first place, but this may be coming. The Wall Street Journal recently reported that China's largest state-run banks have begun preparing for bad loans. Their provisions for bad loans are up for the third consecutive quarter, and they are worried about China's growth slowing (hence the stimulus).

Long-term trends work against China

One of the big challenges is that China has built its economy on a foundation of abundant, cheap labour. But this isn't a long-term solution for any country.

China's working-age population is expected to shrink by a whopping 200 million people by 2050, due in large part to the one-child rule.

As China's workforce shrinks, the remaining workers will demand higher wages due to simple supply and demand. News reports suggest that at Foxconn, where most of Apple's (Nasdaq: AAPL) products are made, the average starting wage was $1.78 per hour. A wage like that would be unthinkable in the developed world, and if China's workforce declines by 200 million, it will be unthinkable in China in coming decades.

How does this end?

We've already seen workers demand marginally higher wages in China, and as the workforce shrinks and the middle class grows, that challenge only becomes greater. If costs go up to manufacture products in China, what will happen to China's export economy?

The big question for China is how it turns a stimulus-driven, export-based economy into a sustainable, consumer-driven economy. China is making some strides in this area, but the current direction has me worried that there could be a hard landing or a financial crisis ahead. There are tens of billions of dollars in loans that seem questionable at best, and China's labour situation seems like a long-term disaster.

Foolish takeaway

China isn't a place I would like to be investing my life savings in today with these challenges. Instead, more stable, safe economies seem like much better bets. Australian investors have a foot in both camps – and getting caught with too much exposure to China could still end badly.

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