We are now in 2012 and there are plenty of talks in the mainstream media about a possible hand-landing for the Chinese economy. In today’s article, we shall not go too deep into the details. This article by Paul Krugman explains the mainstream thinking very well. Nevertheless, despite the mainstream speculation of a possible hard landing, the financial markets are still pencilling in a soft landing. This may change as more data is released to indicate otherwise.

We don’t dispute Paul Krugman’s thesis of why a hard landing is coming. In fact, as we read his articles, we find his argument familiar- in fact, they seem to come from Michael Pettis, a professor at Peking University’s Guanghua School of Management. We read his articles regularly for insights, along with Patrick Chovanec’s. Even our favourite contrarian, Marc Faber is echoing warnings that while all eyes are looking at Europe’s problems, China may surprise on the downside.

Now, from all these ample warnings, we can establish the fact a Chinese economic hard landing will be the most anticipated ‘surprise’. We say it is a ‘surprise’ because 12 months ago, most mainstream pundits will scoff at the idea of China facing a hard landing. Today, they are talking about it. But you have to bear in mind that despite all these talk about it, the mainstream consensus is that whatever is happening to China’s economy today are well within the designs of the Chinese government (or rather, the Chinese Communist Party). The fact is, the Chinese government are engineering some sort of a landing for the Chinese economy. Maybe they may overdo it and err towards the territory of hard landing, giving the economy an extra dosage of tough medicine. But at the end of the day, the belief is that the government is still in control.

Of course, we are not going to argue for or against that. In fact, any self-respecting contrarian should already be preparing for a possible Chinese hard-landing the same way airline passengers prepare for mishaps by putting on seat-belts. In other words, it should be a routine manoeuvre. But what will separate the average from the excellent will be the look out for unanticipated Black Swans. For us, we are trying to evisage what kind of serious mishaps that are outside the designs of the Chinese government that can happen. We shall call that mishap a ‘crisis.’

As we mentioned before in Warning: China MAY be near an economic crisis, we mentioned that

The question was put forth to Victor Shih on what he thought may be the trigger for a financial/economic crisis in China. The usual suspects of what the trigger may be usually comes in the form of an external shock (e.g. collapse of Euro-zone, global recession) that crunch China?s export industry. Surprisingly, that wasn?t his consideration. Victor Shih offered his favourite theory (though he emphasised that it is by no means a prediction) that when it comes to the point when China?s elite begin to pull its vast wealth out of China, that will be the thing that trigger a crisis. This could happen, for instance, when the elite find that the returns on/of their investments inside China is floundering.

Already, there are some anecdotal evidence that this is already happening as this article from the Financial Times reported. On the macro level, we saw this article recently,

China?s foreign-exchange reserves dropped for the first time in more than a decade as foreign investment moderated, the trade surplus narrowed and Europe?s crisis spurred investors to sell emerging-market assets.

For now, the decline in China forex reserves are blamed on hot speculative money pulling out of China i.e. foreigners. But if it comes a day when China’s own elite are pulling out their wealth out of China en masse in sufficiently large volume, it has the potential to develop into a crisis.

How? Let’s imagine this scenario.

Let’s say the Chinese government get spooked by Europe and the collapsing real estate bubble in China. And let’s suppose the Chinese government decide to print copious amount of money and loosen the credit spigot in an attempt to re-stimulate the economy. What if this does not work? Then firstly, the liabilities of the People’s Bank of China will increase. As we wrote in Is China allowed to use its US$2.4 trillion reserve to spend its way out of any potential crisis?,

According to the chart provided by Pivot Capital?s report, only a little over 20% of China?s total currency (plus gross external debt) are ?backed? by their US dollar reserves, which isn?t spectacular compared to other emerging economies. In fact, South Africa is the winner in this aspect because their reserve coverage ratio is almost 160% i.e. it has $16 of reserves for every $10 of currency.

That aritlce was written in 2010. We believe that today, even less than 20% of China’s today currency are ‘backed’ by US dollar reserves. If China prints money even further in 2012, that percentage may go even lower. Now, combine that with capital flight out of China from China’s elite. Then China can face with two stark choices: (1) maintain the peg and have a currency crisis or (2) let the RMB depreciate further and risking a trade war with the US by pissing off Congress.

Now, we have to make clear that this is just a conjecture, not a prediction. It may not happen. Even if it will happen, it may not happen in 2012. But it is something we keep at the back of our minds. If our conjecture turns out true, this is a real Black Swan. Make sure you tell people that you read about it here!