This chart shows why China’s boom could soon turn to bust

Before today, the FTSE100 had dropped by 6% in just over a week. And one reason, says market pundits, has been “Chinese tightening”.

So what does this mean?

In a nutshell, China’s government reckons that its economy is expanding too fast for its own good. 2009 saw 8.7% growth, with a 10.7% annualised rate being reached in the final quarter. The IMF has pencilled in another 10% rise for this year.

Sounds like trouble Gordon Brown would love to be facing.

But all this growth is coming at a price – of property, for example. Values climbed by 40% in many Chinese cities, says estate agent Knight Frank, while new Shanghai apartments cost 68% more than a year ago. Property sales soared by 75% in 2009.

It’s all down to record levels of bank lending. The Bloomberg chart below shows the big picture.

The right hand scale shows year-on-year changes. The green line shows how much China’s M2 money supply – boosted by all that extra bank credit – has swollen over 2009, expanding by almost 30%.

Whenever money supply has increased sharply during the last decade, GDP growth – the blue line – has followed. But so, after a lag, has consumer price inflation, as shown by the red line.

Now China’s authorities are getting worried on two counts. First, that the property boom will spill over into the rest of the economy, causing the prices of consumer goods – and particularly food – to surge. Secondly, that 85% of Chinese, according to official figures, can no longer afford to buy property. Both of these things could create ‘social instability’.

So the obvious answer is to curb credit by putting more controls on bank lending, which is what those authorities are now doing. But getting money supply right isn’t easy. To put it another way, simply count up how many times in history central banks have managed it.

Stock market bulls everywhere are pinning their hopes on China dragging the globe back to economic growth. But we’ve just seen how much damage can be done to stock markets by a bit of tightening talk. If there’s plenty more of the same in the pipeline, cyclical shares worldwide – which need credit and economic growth to make their profits – could yet get hit much harder.

Sticking to defensive stocks like utilities, whose high yields provide some protection against price falls, looks an even better bet right now.