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On May 11 China’s stock market slipped into official bear market territory so quietly you’d think it was no big deal. The Shanghai Composite Index fell 1.9% putting it down 21% from its November 23 high.

What’s next? Predictions fall into two diametrically opposed camps.

There are the China bulls, like old China hand Mark Mobius of Templeton Asset Management, who see the current bear market as a buying opportunity. Stocks in the Shanghai index now trade at 20.2 times trailing 12-month earnings. That’s cheap compared to a 49.5 price-to-earnings ratio for the market at the October 2007 high.

And there are the China bears such as Marc Faber, publisher of the “Gloom, Doom, and Boom Report,” hedge fund manager and short seller Jim Chanos, and Harvard economist Ken Rogoff who are all expecting China to crash in the next six to 18 months.

Why the extremes of opinion?

Because China is trying to execute a maneuver that almost no country or central bank ever gets right. Beijing is trying to slow its economy—which grew at an annual rate of 11.9% in the first quarter of 2010—control inflation—which grew at a 2.8% annual rate in April and threatens to run out of control—and deflate a bubble in assets such as real estate—real estate prices grew at a record 12.8% annual rate in April—without crashing either the economy or the financial markets.

The Federal Reserve hasn’t been able to pull off this kind of move. The European Central Bank doesn’t even try. So why, ask the bears with good reason, should we think that China can?

Because, say the bulls, China is different. China’s state-controlled economy gives the government and the People’s Bank vastly more control than any government or central bank has in the more free-market economies of the developed world. And that will let the government thread the narrow path between slowdown and bust.

My opinion?

It’s not only too early to tell if Beijing can deflate its bubble without crashing the economy, but we’re only just entered the really, really dangerous period when Beijing could actually make a mistake big enough to cause a crash. A crash in China’s controlled economy and financial markets wouldn’t be anything like a crash in the United States, of course. A company or an entire industry in China is only bankrupt when the government says it’s bankrupt. But even a controlled China-style crash would be very painful for investors.

I think the trend in China’s stock markets is still downward, even if the bulls prove ultimately correct, as the Chinese government tries another round of fixes. In my opinion investors will get a buying opportunity in China this year at prices below current levels even if China doesn’t “crash” (whatever that means in the Chinese financial system). I’m advising building some cash so you’ll be ready to take advantage of that opportunity but keeping that pot of “China cash” on the sidelines until you see how the story comes out over the next few months.

Here’s what we know about this bear market so far.

The story behind the bear market to date is pretty straightforward.  Chinese financial markets and China’s economy have been bending gradually under pressure as the Beijing government tries to fight inflation and slow real estate and stock market speculation without tanking the stock market or the economy. The steps to date have been frequent but small. For example, the People’s Bank of China has raised reserve requirements three times this year most recently on May 3. Banks in China are now required to keep cash equal to 17% of their loans on reserve.

Add to that restrictions on second and third mortgages, limits on how many houses a family can buy, warnings to banks about uncollateralized loans, lower lending quotas, and higher yields on money banks leave on deposit with the central bank and you’ve got an impressive series of measured steps to slow lending, speculation, and the economy.

Trouble is that to date these measured steps don’t look like they’ve had much effect. Real estate prices soared at a 12.8% rate in April. That’s the highest rate of increase on record. Overseas money continues to flood into China as investors and speculators bet on continued fast growth in the Chinese economy and a re-valuation of the renminbi. Foreign direct investment rose in April for the ninth month in a row at a 25% annual rate. Bank lending slowed but banks still extended $110 billion in new loans in April. That, if continued, would put bank lending on a path to $1.3 trillion for 2010. That’s disappointingly close to the record $1.4 trillion in new loans in 2009 that the government had vowed to reduce. (For more on China’s inflation problem, see my post )

The failure of these measures—at least to date—pushes the government and the People’s Bank closer to the day when they will have to haul out the big guns: a decision to end the dollar peg for China’s currency and an increase in the central bank’s benchmark interest rate.

Allowing the renminbi to appreciate would stem—gradually—the flow of hot money flooding into the country in anticipation of a quick profit when the renminbi gains in value against the U.S. dollar. That would make it easier for the central bank to reduce the money supply and control inflation. A decrease in the price of imported goods, a result of a more valuable renminbi, would also help reduce inflation.

On the downside, an increase in the value of the renminbi would amount to an increase in the prices that overseas customers have to pay for Chinese produced goods. The big picture effect of a 3% or so increase in the value of the renminbi on Chinese exports is extremely small, but for the thousands of Chinese exporters that work on small or non-existent margins a 3% increase in the renminbi would be enough to push them to the economic brink.

An across the board increase in the benchmark interest rates would be a powerful brake on the economy as a whole, which is exactly why the People’s Bank has been reluctant to use such a blunt instrument. Higher interest rates, the bank knows, would push thousands of margin Chinese companies into at least technical bankruptcy.

This is the point in the Chinese efforts to slow the economy that really marks the difference between the bulls and the bears. The bulls believe that the Chinese economy is strong enough—and government controlled enough to survive a currency appreciation and an increase in the benchmark interest rate without crashing. Bears think that the economy and financial system are so leveraged that those two moves could push over the entire pyramid.

Truth is that the bears are right about the highly leveraged nature of the Chinese economy and financial markets. But that no one really knows how big an increase in the value of renminbi or in the benchmark interest rate would be needed to turn that leverage into a crash.

Take the case of a manufacturer that’s now just getting by. Thousands of companies like this—both big and small—are actually losing money now on their operations. They’re only getting by because they can borrow at very low rates from banks or local-government-affiliated financial companies that aren’t at all concerned with the ability of the company to pay the loan. Many of these marginal companies are making ends meet by using these loans, not in their own businesses but to speculate in real estate or on the stock market.

Other thousands of companies that are now very modestly profitable on their operations would be pushed into similar straits by an increase in the benchmark interest rate or by a currency appreciation that cost them even a few percentage points of overseas sales. They’d enter the ranks of companies that survive only because they can borrow.

But remember that the People’s Bank and bank regulators are making money more expensive and restricting the availability of bank loans. At the same time falling stock prices are cutting into the ability of these companies to make a profit by taking out loans and then investing in stocks. If higher interest rates have also started to moderate the increase in real estate prices—or maybe even sent them into decline—then that removes another source of income for these companies.

Meanwhile back at the bank, bankers are having a harder and harder time classifying these loans as “performing.” Banks have billions in loans on their books that ought to be classified as bad loans but that are labeled performing because borrowers are keeping up with their interest payments by taking out new loans and using them to generate stock market or real estate profits or by using the new loan money to pay interest on the old loans. Many of these loans aren’t backed by sufficient collateral if they’re backed by any collateral at all. Much of the $430 billion in new loans, according to estimates by BNP Paribas, that went out to entities affiliated with local governments last year weren’t backed by anything more substantial than a guarantee by the local government. Since many local governments themselves have only kept afloat by fees on real estate transactions and by profits from rising real estate prices, you can imagine how much those guarantees will be worth if real estate activity and prices start to fall.

That’s the leverage pyramid. Pretty scary, no doubt about it. But exactly how big a push is needed to turn a modest slide downhill into an avalanche?

No one knows. But everybody in the financial industry is desperately trying to figure out what the margin of error might be. Banks, one estimate goes, have enough cushion to survive a 40% drop in real estate prices.

I think that kind of top down estimate for doesn’t consider the role of the Beijing government as not just the lender of last resort—as the Federal Reserve and the U.S. Treasury were in the United States during the post-Lehman financial crisis—but also as the book keeper of last resort.

China’s big banks won’t go under because the government will lend them cash and then allow them to restructure in ways that wipe bad debt off the books. That’s exactly what the government did in the aftermath of the 1997 Asian currency crisis. The bad debt from that crisis that the government rolled over from the big banks to special entities set up to buy that debt with government cash was just buried, and never repaid or liquidated. (For more on how China buried that debt see my post )

I assume that China would do the same thing this time around if bad loans threatened any of the country’s big banks. It would harder because most of these banks are now publicly traded companies. Harder. But not all that hard.

In other sectors I think Beijing would act to save its big national champions no matter what their books looked like. In many industries, though, the government would let smaller, inefficient companies go under or absorb them into bigger companies with government support. Beijing has been trying for years to force inefficient steel companies, coal miners, and export manufacturers out of business only to have its efforts frustrated by local officials who value the jobs these companies produce over profit and loss statements. But if those local officials don’t have the ability to connect these companies with new bank loans, Beijing will finally get its way. (This isn’t a bad thing; in the long run the Chinese economy will perform better without these money-losing, inefficient companies that swallow capital and undercut prices.)

The real estate sector would see a savage shakeout, I’d project, with any company without the most powerful of political connections going to the wall. Real estate isn’t seen as a strategic sector by Beijing. It doesn’t add to exports. And no specific company is so unique that it can’t be replaced. So the deciding factor here will be who has the most sons and daughters of the most powerful officials in government running them or sitting on their board of directors.

That all works to make a worst case crash scenario much less dire than the scene the bears are painting.

Yes, stocks will go down. All stocks. From October 2007 to October 2008 the iShares FTSE/Xinhua China 25 Index ETF (FXI), dominated by big banks and big real estate developers and big exporters fell 64%.  During that same time period the S&P 500 Stock Index fell just 44.4%.

But because of the role of the central government as the source of cash and the keeper of all the books a stock market crash like that isn’t anywhere near as catastrophic for the economy as Lehman, Bear Stearns, American International Group, etc. debacle was for the U.S. economy. The Chinese stock market fell faster than the S&P 500, but it began to recover more quickly as well. The S&P kept falling until March 2009 while the Chinese index began to rally six months earlier.

The Chinese economy slowed. But from 10% growth to 8%. It never dipped into recession.

I certainly don’t think your portfolio would thank you if you took it through a replay of that October to October drop in Chinese stocks. It could still happen. This has been an incredibly orderly bear market to date. No panic. No rending of clothes. No burning investment bankers in the street. (What’s that? It’s supposed to be “in effigy.” Gosh, I missed that.)

But that’s no reason to get lulled into complacency. The bear market so far isn’t the end of the story.

We simply don’t know how this chapter is going to turn out. The odds favor the bulls, in my opinion, but the penalty for being wrong and getting caught up in the bear scenario is so heavy that it makes up for the difference in probability in my opinion.

So why not wait? A few more months will tell investors a lot about whether the Chinese government is successfully slowing inflation and how the markets and economy are reacting to any of the big policy guns that Beijing might need to deploy. Wait. And build some cash. Because when we do know more, when we can better decide who’s right, the bulls or the bears, we will want to put money into a Chinese stock market that will be cheap and ready to perform.

Full disclosure: I don’t own shares of any company mentioned in this post.