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After a sharp upward thrust in June, FXI quickly lost its mojo. A clean break of support in the $38.50 range could invite a new downdraft; on the fundamental side there are very good reasons for this.

A Country of Superlatives

China is, in many ways, a country of superlatives. For instance: Within 20 years, China’s urban areas are expected to swell by another 350 million people – more than the full population of the United States. There will soon be more Christians in China than anywhere else on Earth. And China’s steel consumption is more than twice that of the United States, Europe and Japan put together.

Adding to that list, the International Energy Agency (IEA) now reports that China has become the world’s largest energy user. “In 2000, the U.S. consumed twice as much energy as China,” says IEA chief economist Faith Birol. “Now China consumes more than the U.S.”

Indeed, the dragon is big… but the dragon also has some very big problems, many of which are coming to a head.

Subprime Redux

First and foremost among China’s worries is the growing rottenness of the banking system. Based on the evidence, it is not an exaggeration to say China is repeating the mistakes of the United States and Europe. Chinese banks are making dodgy loans, piling up toxic assets, and using various parlor tricks to keep the dreck off their balance sheets.

(By the way, if you want hear my other reasons to sell China later this week, sign up for Taipan Daily to receive my investment commentary.)

Fitch, one of the big three ratings agencies, released a report last week detailing how China is “distorting credit data.” (You can find a copy of that report here.)

As The New York Times reports, Fitch bluntly charges that “Chinese banks were increasingly engaging in complex deals that hid the size and nature of their lending, obscuring hundreds of billions of dollars in loans and possibly even masking a coming wave of bad real estate and infrastructure loans.”

Hmm. Sound familiar?

Along with that unsavory charge, Fitch further reports that “Chinese regulators understated loan growth in the first half of the year, by 28 percent, or about $190 billion, and that many banks continued to secretly shift loans off the books, creating a ‘pervasive understatement of credit growth and credit exposure.’”

Does human nature ever change? Nope. As Yogi Berra might say, it’s “déjà vu all over again.”

An IPO Hail Mary?

Some in fact argue that the initial public offering (IPO) for AgBank, the Agricultural Bank of China, was in fact something of a desperate cash grab, in the hopes of propping up an increasingly shaky structure. (Prior to the IPO, AgBank was “technically insolvent.”)

“Agricultural Bank of China's $19 billion IPO made a lackluster debut in Shanghai,” Reuters reports, “weighing on the market and underscoring the difficulty other Chinese banks will face tapping investors for billions more.”

"There's a lot profit-taking pressure from investors, who are not optimistic about the long-term prospects of China's economy or the banking sector," said Liu Jun, analyst at Changjiang Securities in Wuhan.

"The debut reflects worries over slower growth and rising bad loans at Chinese lenders, and continued weakness in the stock may prompt a renewed slump in the overall market."

As with the recent Tesla IPO, which put $226 million into the company’s coffers but burned late-to-the-party investors badly, the AgBank offering looks like another example of greater fool theory at work.

And just who are these fool-me-twice investors rushing to buy what insiders are selling? Did they not learn from the infamous Blackstone IPO of 2007, in which the proprietors quite literally top-ticked the market with their cash outs?

If you are, say, the Qatar Investment Authority (who invested $2.8 billion in the Agbank deal), there are at least theoretical reasons to justify participation: Mountains of excess cash, the sovereign relations motive, and so on. But if you are a nimble private investor, why oh why give up your two best edges – flexibility and selectivity – to throw precious capital at such a dog?

Bigger Fish to Fry

If China’s banks were the only reason to worry, the bulls might have a leg to stand on. Beijing is not shy, after all, about blurring the lines between public and private enterprise, and the dragon is theoretically cash-rich enough to absorb a deluge of bad debts.

The trouble, though, is that China’s dodgy banks are only the highly visible tip of a much bigger iceberg… and the macro level problems brewing in housing and labor markets are even more worrisome.

Human nature being what it is, Beijing is following in Washington's footsteps. The mandarins are propping up rotten institutions with public cash, then looking the other way as toxic problems get papered over.

If banks were the only problem, the odds of a "soft landing" for China would be higher. Trillions of dollars in reserves can come in handy for writing off bad debts. Record reserves don't count out the possibility of a crash, however, as we saw with Japan in the late 1980s and the United States prior to 1929.

Apart from the banks, China's big troubles come down to real estate, labor and exports. China's insanely inflated real estate market is tottering... labor costs are rising... and the mighty export machine is under threat.

Home Is Where the Hype Is

"China views soaring house prices as a threat to social stability," the U.K. Telegraph reports, "since workers are shut out of the market. The price-to-earnings ratio is 13 in Beijing and Shanghai, four times Western levels."

Charles Dumas, of Lombard Street Research, argues that real estate has soared because wealthier Chinese investors - the moneyed class - have a distinct lack of options for their cash. Real interest rates in China are "negative," meaning the official rate of interest is below the rate of inflation, and capital controls make it hard to invest abroad. So China's wealthy buy up real estate as a fallback option, and thus create a self-reinforcing feedback loop of rising prices and confidence.

"Wealthier families often hold three, four, or more properties as a hard asset to store wealth," the Telegraph adds, "leaving many vacant. This has disguised the scale of excess inventory..."

It is hard to know just how big the "excess inventory" truly is, but every indication suggests that it is huge. One prominent Chinese economist, as cited by the South China Morning Post, believes there could be as many as 64.5 million dwellings with nobody home:

Yi Xianrong, an economist at the Chinese Academy of Social Sciences, a government think tank in Beijing, noted estimates from electricity meter readings that there are about 64.5 million empty apartments and houses in urban areas of the country, many of them bought up by people wagering on a constantly rising property market...

Ken Rogoff, a former IMF chief economist known for historical analysis of sovereign debt issues, thinks the Chinese real estate market is already on the verge of imploding. "You're starting to see that collapse in property and it's going to hit the banking system," Rogoff says.

Ah yes, the banking system. Because it's all connected of course...

Not everyone thinks the China real estate bubble is about to burst. Stephen Roach, chairman of Morgan Stanley Asia, publicly argues there is no true bubble at all, because a steady flow of rural Chinese migrating to the cities should prop up demand.

Your humble editor would love to ask Mr. Roach just how these migrants will be able to afford a new home at current sky-high prices. At the height of the U.S. housing bubble, California unveiled the "50-year mortgage" as a way to keep middle-class families from being priced out of the market. Will China do one better and unveil the 100-year mortgage, or even the 150-year mortgage, thus extending the "engagement till death" compact to second and third generations?

The notion that China's bubble can be sustained is madness... but it's an old familiar madness. It is the same combination of blind hope and compromised self interest that has temporarily forestalled collapse so many times before, put forth by those who want to keep the good times going at all costs.

One might further note that Mr. Roach, he of the "no bubble" persuasion, is head of an investment bank division that seeks, above all, to maintain good business relations with China. As Upton Sinclair once said, "It is difficult to get a man to understand something when his salary depends on not understanding it." That goes triple on Wall Street.

Labor Also Rises

What's more, the bloom is coming off the real estate rose just as labor competition intensifies. As The New York Times reports,

As costs have risen in China, long the world's shop floor, it is slowly losing work to countries like Bangladesh, Vietnam and Cambodia - at least for cheaper, labor-intensive goods like casual clothes, toys and simple electronics that do not necessarily require literate workers and can tolerate unreliable transportation systems and electrical grids.

Li & Fung, a Hong Kong company that handles sourcing and apparel manufacturing for companies like Wal-Mart and Liz Claiborne, reported that its production in Bangladesh jumped 20 percent last year, while China, its biggest supplier, slid 5 percent...

Workers in Chinese factories, once cheaper than dirt, are now demanding higher wages. The wage component may still be modest as a function of total production cost, but that can be no comfort to many of China's embattled export companies, who were already working with razor-thin profit margins.

The optimistic argument is that China is merely going through a stretch of growing pains, and that labor hiccups involving strikes and wage increases can be sorted out. It is suggested that wage-sensitive giants, like China's FoxConn, can simply move operations inland, arbitraging cheap labor away from the coasts as general wage pressures rise.

The part about growing pains is undoubtedly true - but it comes at a most delicate time. China may find that its legendary cheap-labor engine is stuttering and backfiring just as a massive property bubble threatens to burst, against a backdrop of creeping global slowdown.

How Much Capacity?

There are other burning questions as to just how export-dependent China really is, and how exposed China might be to capacity investments gone bad. (Picture a billion-dollar factory, built on credit, with half the assembly lines gone dark for lack of demand.) It is no good for the "shop floor to the world" when the world collectively tightens its belt.

Yao Jian, spokesman for China's Ministry of Commerce, warned last week that the export picture would darken. The picture is "still complicated and grim," he said, adding that "the room for the further growth of Chinese exports is limited."

This raises a point of serious concern. Just how much has China already invested in what was once believed to be a rosy growth outlook? How many roads, bridges, highways, factories, ports and so on have been constructed - many of them with stimulus funds - in the assumption that the dragon would soon "grow into" their use?

Consider the stimulative impact of, say, building an eight-lane highway. The actual construction of the highway may create a short-term economic boost. As the highway is being built, contractors and construction workers are being put to work, raw materials are being used, jobs are created and sustained, and so on.

But once the highway is built, then what? If no one is in place to use it, or more importantly enhance their productivity by using it... if there is no positive longer-term economic impact from its creation... then the stimulus effect simply fades away, and the project reverts to an inert slab of concrete. The highway - or factory, or office building, or shopping mall - becomes another empty artifact in an empty landscape, of little more use than a monument to folly.

The views of optimists and pessimists again diverge widely here. Optimists hear all the reports of buildings unused, roads left idle, and cheerily assume that China's economy will quickly "grow into" this shiny new infrastructure, like an energetic young boy growing into his older brother's clothes.

The pessimists, on the other hand, concede that China may eventually grow into the glut of infrastructure it has built - but with the caveat that the process could take years, or even decades, depending on just how badly China overestimated the appetites of its customers.

Meanwhile, the pressures of global economic slowdown, combined with a collapse-prone real estate market and low-end labor competition, mean that the dragon's much-vaunted growth rate could simply fall off a cliff.

The potential for a "numbers shock" lies in the nature of stimulus-supported infrastructure growth, idle production capacity, and thin profit margins on the labor side of the equation. It is all too easy for a small profit, magnified through leverage, to swing to a large loss.

And on the whole, the problems are too big to throw cash at, even with pockets as deep as Beijing's...