5 Land Mines for Chinese Stocks in 2011

A very large grain of salt. That’s what economists suggest you take when digesting Chinese economic numbers.

The country’s financial planners tend to massage key numbers to give the impression of an economy that is neither too hot nor too cold. To its credit, China’s decade-long growth spurt has been truly miraculous and policy planners seem to continually pull the right levers, even though those choices are often antithetical to Western economic dogma.

Much of China’s success has come from its status as a low-cost provider of goods and comparatively low levels of per capita GDP, which enabled it to grow without bumping into hurdles that often come when economies achieve world-class status.

But those days are over. China’s economy is now far larger — having recently surpassed Japan to occupy the No. 2 spot — and the government ‘s task of managing growth has become ever-more complex. Even as Chinese economic planners will continue to massage the numbers to give the appearance of a smooth-sailing ship, 2011 offers more potential pitfalls than ever. If you’re invested in China, here are five items you’ll need to watch:

1. An unhealthy bank sector. The biggest flaw of a centrally-planned economy is a misallocation of resources. So when China decided to use its state-owned banks to promote a massive build out of residential and commercial real estate, it ran the risk that those projects would not see enough demand. That’s now become a reality as China is said to be sitting on millions of square feet of empty commercial and residential real estate.

More than likely, China will need to inject massive amounts of liquidity into those banks in 2011 to keep them afloat. At the same time, China is likely to conclude that enough is enough, and future real estate lending terms will be much stricter. And that could set the stage for a massive construction hangover, just like we’re seeing in the United States.

2. Cooling job growth. Here in the U.S., worries and anger over persistent joblessness has led to a change in political leadership. In China, no such outlet exists. Instead, Chinese workers tend to take to the streets to protest a range of labor-related concerns. Relatively high employment levels have kept any restlessness at a low boil, but Chinese leaders know that any increase in unemployment could have dire social consequences and undermine leadership’s legitimacy.

That’s why Chinese leaders have aggressively stimulated the economy, building roads, trains and skyscrapers at a break-neck pace. Yet the government has already played that hand, and policy planners know that Japan erred by building too much infrastructure that went on to be under-utilized. So these planners are hoping that the private sector can pick up the slack and hire many of the workers that may soon be laid off from public works’ programs. Navigating that path may prove bumpy.

3. The yuan dam may burst. China has done an impressive job of recycling foreign earnings back into foreign investments, which is one the reasons its currency hasn’t appreciated sharply as expected, as trade surpluses build.

In recent years, China has sought to recycle some of those foreign-earned profits elsewhere to reduce a heavy exposure to the U.S. dollar and the U.S. economy. But China’s total foreign holdings are now so massive, and its foreign earnings continue to pile up so quickly (with fewer places to go), that the country will soon have no choice but to bring some of that money back home. Yet by repatriating foreign earnings, China’s currency is bound to feel the pressure to move higher.

China is keeping a lid on this by maintaining a tight band on the value of its currency, but the longer it allows the pressure to build, the greater the unforeseen effects will be when the currency finally floats freely on global markets. Chinese planners can either maintain the status quo, and set the stage for a real headache down the road, or start to shift policy soon to start to alleviate budding currency pressures. How Chinese economic planners navigate this policy will be a true test. A sharp spike in China’s currency would devastate its export-led economy, but inaction would prove to be equally harmful.

4. Increasing trade tensions. While China is keeping its currency weak by pegging it to the sinking dollar, trading partners throughout Asia are starting to grow annoyed. The Japanese yen, the Thai baht, and the Malaysian ringgit have all appreciated at least +10% against the yuan this year. And while that’s great for China’s exporters, other countries are quickly losing their competitive edge. The issue should dominate discussions to be held by the Group of 20 (G-20) nations on November 11 and 12 in Seoul, South Korea. It’s not clear how China will be able to continue avoiding this issue if it is to avoid even more anger among trading partners and neighbors in 2011.

5. A growing political rift. Lastly, the Chinese leadership is no longer moving in lock-step on key issues such as freedom of the press and corruption, and this threatens to evolve into a major internecine battle. China’s Premier Wen Jiabao noted on Newsweek columnist Fareed Zakaria’s GPS program on CNN last month that China will need to open up and develop greater transparency if economic growth is to continue. His comments were quickly denounced by other members of China’s leadership and were ultimately expunged from the public record. But other members of China’s leadership quickly came to Premier Wen’s defense. Although unlikely, this increasingly factionalized environment could ultimately lead to a major rift among key policy makers.

Action to Take –> It’s been smooth sailing for China. Yet the waters are starting to get choppy, and investors need to brace for potential problems in 2011. If you hold any Chinese stocks, keep these points in mind heading into the New Year. Depending on how these situations play out, you may want to reassess your positions.