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Eyeing the Bubble as China Pulls Back

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Strategists debate Beijing's exit strategy.

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To investors, Beijing is suddenly looking like the Boogeyman.

Looking over the latest data, there's no doubt that China continues to glow with red-hot growth. Dr. Ed Yardeni of Yardeni Research rounds up the latest numbers for us: Real GDP jumped 10.7% year-over-year during the fourth-quarter; for 2009, the economy grew 8.7% year-over-year, shooting past the government's 8% target.

More data for number crunchers to mull over: For the fourth quarter of 2009, industrial production was up 18% versus the year-ago period; retail sales surged 17.5% year-over-year in December.

But now China is taking definitive steps to clamp down on its growth. The Wall Street Journal points out this morning that the boys in Beijing have ordered credit officials to rein in local currency loans because lending growth is too rapid, a decision that follows on the heels of Monday's move of another restriction on lending.

China's decision to implement an exit strategy from their monetary and fiscal easing has investors spooked. There's now a lot of hand-wringing, Yardeni argues, about the sustainability of China's economic expansion if central bankers over there are now going to tap on the brakes.

The iShares FTSE/Xinhua China 25 Index Fund (FXI), an exchange-traded fund that tracks Chinese companies traded in Hong Kong, has fallen 6% in the past five days.

Yesterday, a number of companies tied to the global growth story took a beating, including Alcoa (AA), Caterpillar (CAT), Exxon (XOM), and Chevron (CVX).

Yardeni, however, offers a contrarian take on this story, placing a positive spin on these moves by the Chinese.

In his morning missive, he writes, "This is what typically happens when economies transition from recession to recovery, and no longer need government stimulus once self-sustaining growth takes over. That's a good thing."

The strategist adds, "Yet, for some reason, investors seem to be panicked that China won't manage the transition successfully. I think the Chinese will do so. Indeed, I think that by acting now to cool off their economy, they are increasing the chances that their economic expansion will last longer and won't end badly with the popping of speculative bubbles."

Of course, as we wrote in a previous article, As China's Economy Grows, So Do the Skeptics, there's a well-regarded platoon of strategists and market pros that don't believe the hype when it comes to China, including short-seller Jim Chanos, founder of Kynikos Associates, and James Grant, editor of Grant's Interest Rate Observer, who had this to say:

"Early or late, we say, the economy of the People's Republic will hit something bigger than a speed bump. It will suffer inflation or deflation or a hybrid disorder suitable to an economy that manages to combine the worst features of capitalism and socialism."

Another skeptic is Vitaliy Katsenelson, the vice president and portfolio manager with Denver-based Investment Management Associates. He doesn't agree with Yardeni's upbeat take on China's future.

"If China had continued to do nothing then the bubble would have become bigger and, when it deflates, it would be even more painful," Katsenelson told us in chat this morning. "But the truth is that the bubble has been inflating for a long time. There is already significant overcapacity in the real estate sector."

He continues, "I think they are doing the right thing, but it's too late. They are still going to have plenty of pain when this bubble bursts. There is no miracle to their growth. The recipe is simple: pump a lot of money very fast and force people to spend it. But China doesn't operate in a different economic reality than the rest of us. The same laws of economics apply there."

Katsenelson isn't a short seller like Chanos so, to play his pessimistic theme on China, he doesn't have to nail the timing of his forecasted freefall for the country.

"In my case, I avoid," he says. "I have very little exposure to anything related to China, whether that's commodities or industrials."

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