HONG KONG (MarketWatch) -- China's economy is teetering on the edge of a major slowdown, though it's not a shakeout in the property market that's about to spark the distress, according to a noted China strategist.
David Roche, an economic and political analyst who manages the Hong Kong-based hedge fund Independent Strategy, says the world's third-largest economy is now on the brink, faced with the inevitable reckoning that follows an extended bank-lending binge. "We've got the beginnings of a credit-bubble collapse in China," said Roche, predicting the economy will likely cool from its stellar double-digit growth rate to a 6% annual expansion as a result.
While that may not sound bad, Roche believes the collateral damage from the cooling will be anything but mild, as the banking sector comes under pressure from cumulative years of bad investment and mispriced capital.
"The economy in China has peaked, unless the economy in the U.S. really gets going and drives exports," Roche said.
The emerging picture is one of a substantial contraction in credit growth and infrastructure expenditure, he says.
The shrinkage is grim news for an economy heavily dependent on such outlays. China managed to escape recession during the global crisis mainly because of bridges, railways and other infrastructure-project spending, estimated to have accounted for about 90% of economic growth last year, according to Roche.
About 85% of the funding for these projects was arranged by local government financing vehicles "borrowing money they can never repay" from state-owned banks, says Roche. Nearly 3 trillion yuan ($440 billion) of the 11 trillion yuan extended to these entities has been wasted or stolen, he estimated.
Economic data for April released Tuesday showed China's inflation accelerated from March, beating expectations, while bank lending also surged ahead at a surprising fast rate. See full story on April inflation and other data.
Roche said he's betting against China's banking sector in the expectation their share prices will get hammered as problem loans begin to mount, exposing such institutions' thin capital buffers.
"What do you think a bunch of ex-Communist Party officials in Chinese banks ... know about growing credit at 30% a year?" he said.
More worryingly, as bank lending dries up, there won't be the firepower to sustain new investments in infrastructure, eroding a core pillar of China's growth model, he said.
Much of the focus on potential asset bubbles in China has been on the property sector, but Roche suggested that housing-price inflation is intertwined with unsustainable gains in other areas.
