Will China repeat America's credit crisis?

It seems like nothing can spook this market. Not a pullback in the flow of bond buying stimulus from the Federal Reserve. Not disappointing corporate earnings. Not even disappointing housing and consumer sentiment data.

Instead, the major averages stay aloft -- at technically overbought levels with extended bullish sentiment -- continuing the near-perfect 45-degree uptrend enjoyed throughout 2013.

But it's not all sunshine and roses everywhere. Indeed, while U.S. markets hold steady emerging market stocks are being pummeled by a combination of slowdown concerns, capital outflows caused by a stronger dollar, and lost export competitiveness as Japan actively devalues the yen. You can see this in the way the iShares Emerging Markets (EEM) has traded below its 200-day moving average all month.

Chinese equities, in particular, are looking very weak here as the global investing honeymoon with the Middle Kingdom comes crashing back to earth. Maybe it's the choking smog that essentially closed Beijing this week. Or maybe it's the more antagonistic foreign policy stance, with hypersonic nuclear missiles and navy war games near disputed islands in the East China Sea.

Alternatively, the downturn in Chinese stocks may stem from the realization that the massive credit expansion seen in China since the financial crisis is starting to sour. The country's total credit outstanding stands at around 210 percent of GDP, versus 120 percent back in 2007, according to Goldman Sachs. Much of this was used to fuel real estate investment and construction of physical plant and machinery -- bets that are starting to go bad.

That's because Beijing realizes the situation is untenable and has been trying to cap credit growth by tightening liquidity in the banking system. That's caused turmoil in the inter-bank funding market and is now threatening off-balance sheet investment vehicles -- of the type that popped the U.S. housing bubble as subprime mortgages defaulted and the trouble cascaded through the financial system.

The Industrial and Commercial Bank of China, the world's largest bank by assets, recently said it has no plans to use its own money to repay investors in a troubled off-balance-sheet vehicle. The vehicle, worth $500 million that is set to mature on January 31, made a loan to unlisted coal company Shanxi Zhenfu Energy.

The structure, ironically dubbed "2010 China Credit/Credit Equals Gold #1 Collective Trust Product," is under pressure for a number of reasons. For one, the company's vice chairman was arrested for accepting deposits without a banking license. Second, the company has taken out other high-interest loans that bring its total liabilities to nearly $1 billion, threatening its ability to repay. Third, China's coal interest is under fire as factories slow and coal prices fall.

We'll find out soon what Chinese authorities and bankers will do when this all goes sideways. But I can't help but be reminded of what happened back in 2007 when off-balance sheet vehicles tied to housing started to fail and banks -- after a Treasury Department proposal to pool assets to buy bad mortgages was rejected as too slow -- started bailing the vehicles out themselves.  

For now, I continue to recommend my clients bet against Chinese equities via the ProShares UltraShort China (FXP), which is in my Edge Letter Sample Portfolio and is up nearly 14 percent this month.

Disclosure: Anthony has recommended FXP to his clients.  

Anthony Mirhaydari is founder of the Edge, an investment advisory newsletter, as well as Mirhaydari Capital Management, a registered investment advisory firm.

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