Is China slowdown government policy or impending crash?

This photo taken on June 6, 2013 shows visitors (L) watching the hot rolling process at the Baosteel steel mill in Shanghai during a tour of the plant. China's industrial output rose 9.2 percent year-on-year in May, marginally weaker than the 9.3 percent increase in April, official figures showed amid concern over the outlook for China's economy, the world's second biggest, which grew at its slowest pace in 13 years in 2012. AFP PHOTO/Peter PARKS (Photo credit should read PETER PARKS/AFP/Getty Images) PETER PARKS

(MoneyWatch) Is China's economic slowdown the result of Premier Xi Jinping's efforts to reform the economy or the sign of a crash in the making?

On Monday China's purchasing managers' index registered its sharpest fall of the year, declining to a nine-month low of 48.2 in June. Anything below 50 on the index means that Chinese factory output is contracting. The primary reason for the slowdown is the government's move to a tighter currency policy. This is part of Premier Xi's plan to rein in GDP expansion in order to get the nation on a path of slower, more sustainable growth.

"Falling orders and rising inventories added pressure to Chinese manufacturers in June," Hongbin Qu, co-head of Asian economic research at HSBC, said in a statement. "And the recent cash crunch in the interbank market is likely to slow expansion of off-balance sheet lending, further exacerbating funding conditions for SMEs [small and medium enterprises]. As Beijing refrains from using stimulus, the ongoing growth slowdown is likely to continue in the coming months."

Under the previous regime's policy of easy credit, factories continued to produce whether or not there was any demand for their product. This was seen as a way to avoid the social turmoil that could come with rising unemployment. The effects of that policy are still being felt. The official Xinhua news agency reported earlier this week that the output of China steelmakers was rising despite falling prices.

Also, the easy credit spurred a boom in residential, commercial and government construction that far outstripped any possible current need. Nationwide, Chinese malls have a 30 percent vacancy rate, and some areas are seeing rates of 70 percent. Some developers have waived rents and even offered to outfit stores for large, higher-end retail chains. Many local governments are believed to be either underwater or on the brink of it as a result of borrowing to pay for construction.

In residential real estate, however, there has been a price bubble for several years despite this excessive construction. This was caused by wealthy savers looking for places to put their money where it would keep its value. The interest rate on deposits in China has been negative for years, making real estate much more attractive. (The tight money policy has recently pushed deposit rates into positive territory.) This was encouraged by local governments, which made a lot of money selling land to developers, and by far-too-cozy arrangements between the developers and the banks they borrowed from.

In a worrying sign, the price increases have continued in the face of the government's three-year campaign to slow the market. In March the government strengthened its efforts by raising down-payment and mortgage requirements. It also levied a first-time-ever property tax in Shanghai and Chongqing and enacted purchase restrictions in about 40 cities. Nonetheless, new home prices increased 6.9 percent in May.

Tightening the credit markets will almost certainly slow this trend if it does not reverse it outright. The question now is whether the bubble will deflate slowly or suddenly. A slow drop in prices would allow the government to better manage the fallout and contain any social unrest it causes. A sudden drop will force Beijing to scramble to prop up failing banks and other institutions that have large real estate investments. While the government has the cash to cover the financial cost, the societal impact could be the real problem. And the effects of any sudden burst of the bubble would have international repercussions: China is the world's second-largest economy and problems there would only exacerbate the slowdown gripping the rest of the world.

China is already seeing an increase in protests over everything from pollution to government corruption, and in a nation with no significant social security net, a sudden increase in unemployment is the last thing the government wants.

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    Constantine von Hoffman is a freelance writer and writing coach. His work has appeared in outlets such as Harvard Business Review, NPR, Sierra magazine, Brandweek, CIO, The Boston Herald,, CSO, and Boston Magazine.