The threat from China

Amid all the self congratulation about India overtaking China in terms of GDP growth rates, the relative size of the economies is rarely mentioned. The Chinese economy ($10.4 trillion in 2014 according to IMF estimates) is more than five times as large as the Indian economy ($2 trillion).

India contributes around two per cent to global trade (imports plus exports), while China contributes over 11 per cent to global trade. China contributes more to global trades than even the USA, despite being much smaller than America.

To put this in perspective, the Chinese economy is about 45 times as large as that of Greece and traders have worried about the implications of a Greek collapse for quite a while. What happens if China sees serious turmoil? There can be no clear answers except to say this would be cause for grave pessimism.

China's stock market is in the middle of what seems like a massive bubble. Valuations for many frontline stocks are in triple digits. The Shanghai Composite Index gained over 130 per cent between May 2014 and May 2015.

Valuation estimates are difficult to get and may be deceptive. The Shanghai Composite trades at a forward PE of 19, which doesn't look too high. But the median valuation of all stocks on Shanghai is at a forward PE of 58 and that is clearly bubble territory, given a slowing economy.

The index saw 13 per cent correction in last week. Part of this is due to a series of big IPOs. Investors are booking secondary market profits to subscribe to the newcomers. But there is also strong consensus that China is in a bubble and this could burst, or deflate. Most China watchers also say that there is also a big bubble in real estate.

What could be the outcomes of a big correction? The last time China saw a big correction was in 2008. The Shanghai Composite lost 70 per cent that year.

Multiple possibilities exist. One is that investors will book profits in orderly fashion and move money out to other emerging markets. In that case, India could get lucky since some of the money will arrive here. Another possibility is sheer panic if the market crashes so fast that all profits are wiped out and there are no buyers. In that case, spooked investors might head back into the safety of hard currency debt such as US Treasuries. There are various "in-between" scenarios but the Chinese stock market is prone to extremes, as indeed most equity markets are.

Some analysts assume that the Chinese government will manage to deflate both the bubbles in controlled fashion. Perhaps this can be done but it may be more difficult than anticipated. The "shadow banking" or gray economy in China is tied to speculation in both stocks and real estate.

The gray economy is at $6 trillion equivalent, or nearly 60 per cent of GDP, according to some estimates. A collapse in equity and/or real estate would impact this segment hard. As with India's black economy, the Chinese shadow banking economy is also somewhat impervious to normal monetary measures such as interest rate cuts or hikes.

It's impossible to envisage turmoil in China without the global economy being badly affected - the contribution to global trade is simply too large. This could end up being a bearish factor to watch out for. If China does implode, unlike a Grexit, the consequences will not be temporary. The possibility of a Chinese bubble is good reason for traders to remain braced for deep global corrections.

The author is a technical and equity analyst