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Red Flags In China Hit Stocks Worldwide

Global stocks took a pounding Thursday as troubling news from China added to investors' ongoing selling in reaction to the Federal Reserve's plans to wind down quantitative easing.

The bad news: The preliminary HSBC/Markit Economics Purchasing Managers index for China fell to 48.3, below the 50 boom-bust level and worse than expected.

Worse news: A credit crunch in China, which has been brewing for some time, came to the fore Thursday. The seven-day repurchase rate soared 270 basis points to 10.77%, its highest yield since at least 2003, according to Bloomberg News. The one-day rate exploded 527 basis points to 12.85%. That rate screamed as high as 30% during Thursday's banking hours, as borrowers frantically searched for lenders.

Coming on top of Wednesday's ill-received message from Fed Chairman Ben Bernanke, China's events cast a chill over the region, which added to the urge to purge Asian stocks.

Worldwide Market Sell-Off

The benchmark indexes of Hong Kong and Shanghai dived 2.9% and 2.8%, respectively. India's Sensitive 30-share index lost 2.7%. Japan's Nikkei 225 sank 1.7%.

Bourses in Europe, where troubled economies face an even grimmer future without the Chinese growth engine, got clobbered. France's CAC-40 dived 3.7%, Germany's DAX-30 3.3% and the U.K.'s FTSE 100 3%.

The selling continued in the U.S., with the Nasdaq falling 2.3% and S&P 500 2.5%, pushing the market back into a correction.

The 10-year Treasury yield rose 10 basis points to 2.42%, a fresh 52-week high. Yields pushed sharply higher in every major economy.

Gold, copper, oil and other commodities fell sharply as the dollar spiked and growth concerns increased.

China's credit shortage is no accident, said Jay Bryson, global economist with Wells Fargo Securities.

"This is a policy-driven decision by the government to try to slow lending (to selected hot pockets of the economy)," he said. The hottest pocket that worries Beijing is the property market, where banks have been sourcing loans for speculative buys.

"The central bank is trying to make the statement: 'You guys are making risky loans to property developers, and we're going to slow you down.'" Bryson said.

The credit squeeze has been building for a while. A government debt auction June 14 failed — it could only move two-thirds of its bonds and bills at an acceptable rate. Even the paper sold went for far-above-normal rates.

In addition, one can point to the reduced foreign inflows to account for the lack of credit, says Nicholas Borst, research associate at the Peterson Institute for International Economics, a Washington, D.C.-based think tank. Those inflows are a prime source for banks' deposits and, in turn, loans.

China's "liquidity event" will be a short-lived affair, said Wells Fargo's Bryson. "I don't think even a month from now we'll be talking a lot about this," he said. "You can already see the Chinese economy slowing significantly.

PBoC's policymakers may be thinking they overdid it. Reports are circulating that the central bank last night added $8.2 billion to the financial system, seeking to cool down those soaring deposit rates.

If so, it was done quietly and with no fanfare, just as Borst would expect. "It's a bit of a reversal for them," he said.

Did the cash squeeze set off the weak factory data? Probably not, Borst said.

If the credit scramble were at fault, he said, nonperforming loans from China's manufacturers would be rising. That hasn't happened, said Borst, who tracks such events. Rather, he points to a lethal combo: vast overcapacity among China's manufacturers — especially in heavy industries such as steel and aluminum — and weak demand for China's exports. Even domestic demand is waning.

"The excess capacity problems, which have been brewing for a long time, now are coming to bear," he said. China's manufacturing is still an inefficient, fragmented lot. For years, each had been striving to be the biggest and the best, and that led to a race to add capacity, Borst explained.

The result is a patchwork of thousands of factories, many subsidized, all getting the benefit of China's cheaply pegged currency (which promotes exports) — and many of which are losing money. Beijing has for years been encouraging consolidation among the country's factories, and Borst says you can expect more of that — and less investment — going forward.