Even China admits a hard landing is getting more likely

With China's government cutting its growth forecasts, things are likely to get much tougher for the world economy. Matthew Partridge explains why, and how to profit from a Chinese downturn.

If there is one issue that divides the world of investing more than any other right now, it's China.

On the one side, you've got those who think the Asian giant is going to keep growing, growing... and growing.

Others point out that China is not immune from the rest of the world's woes and that it has its own batch of problems to deal with on top.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Regular readers will know that we're in the bearish camp. China's economic successes over the past 30 years have obscured the fact that its institutions still have plenty of room for improvement, and that the state controls much of industry.

That's fine at the early stages of development. It's one way to get things done quickly. But as it gets richer, these problems start to matter more. This will make it more vulnerable to shocks.

And confirmation that things could get much tougher than the optimists expect has come from an unexpected source the Chinese government.

China cuts its growth forecasts

One of the problems China observers have is that the data simply isn't that reliable. The Chinese state uses a mixture of carrot and stick to keep Chinese citizens in line: the carrot is ongoing economic growth and improving standards of living.

This means the government is anxious to show that the economy is advancing quickly even when it clearly isn't. For example, as Cris Sholto Heaton noted in MoneyWeek Asia recently, there were at least five periods of very low growth between 1979 and the present day. However, none of these are reflected in the data.

So when the Chinese Premier Wen Jiabao cuts the growth target to 7.5%, it's clear that he is managing expectations lower. He also suggested that exports were likely to grow at a slower rate in the future.

Of course, the political spin on this is that lower growth is all part of a grand plan to increase domestic demand. He also made noises about economic reform. However, it's like a politician resigning "to spend more time with my family" - you know that it's just an excuse.

This is bad news for commodity prices

So what does all this mean for markets?

As we've noted before, the biggest losers from a Chinese hard landing are going to be commodities, industrial materials in particular. China's economic growth has turned it into a major consumer of raw materials. For instance, it accounts for around 40% of copper and aluminium consumption. This means that both those metals and others, such as iron ore - should be badly hit by a slowdown.

Of course, there are exceptions. A lack of attractive alternative investments has seen Chinese investors flock into gold. Wen Jiabao also restated plans to increase defence spending, so prices of related metals such as tungsten - should hold up.

The Middle Eastern crisis also means that oil prices could well remain high in the short run. Capital Economics thinks that Brent will remain above $100 in the first half of the year. However, the research group also believes that crude could fall to as low as $85 by the end of the year, on the back of falling demand.

If China sneezes, Australia will catch a cold

A Chinese slowdown will also hit Australia hard.

Up until now, Australia's role as an exporter of primary materials and its trade links with the People's Republic a quarter of its exports go to China - mean that it has performed strongly, even as other developed economies have slumped.

Australia has only had two quarters of real negative growth in the past ten years. Since 2004, unemployment has never risen above 6% - it is currently 5.1%. However, a Chinese slowdown will whack it with a double whammy of falling exports and worsening terms of trade (it'll no longer be exporting lots more than it imports).

Australia also has a third problem it still has a rampant housing bubble. According to The Economist, house prices are 40% above their historical levels relative to income. That can't go on.

Indeed, the bubble may already have popped. According to the Australian Bureau of Statistics, the average house price in eight major cities fell by nearly 5% from December 2010 to 2011.

Both JP Morgan and Saxobank believe that there is a good chance Australia could go into recession. And to be fair, if you read the local press, it's clear that many Aussies who don't work in the mining sector feel like they're already in one. Tim Colebatch in The Sydney Morning Herald points out that the latest data shows that the non-mining parts of the Australian economy are not growing.

Short the Aussie and Copper

So how can you profit from a Chinese downturn? As we've pointed out already, shorting the Aussie dollar is probably the most straightforward play. The ETFS Short AUD Long USD (LSE: SAUP) fund has gained in price since we last tipped it, but the Aussie could fall a lot further if China's economy really slows down. We would point out, however, that speculating on currency movements is a risky business, and this is not a buy and hold' investment.

Sign up to receiveour free spread betting email MoneyWeek Traderfor more on currency trading andspread betting.

Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri