The highly credible HSBC/Markit Purchasing Managers' Index (PMI) of economic demand in China reported that demand in China's factories fell for a second month in a row and hit a seven-month low. Markit Research also reported that production turned negative for the first time in seven months and hiring expectations fell to a new five-year low. Although the Chinese government continues to produce an array of rosy economic statistics each month, China's industrial competitiveness is fading fast. Coupling the production contraction with banking problems and a fall in the HSBC/Markit Employment Index to a five-year low, it appears that China's economic bubble is bursting.

Markit Research compiles "flash" indicators each month for demand and operating conditions in China's manufacturing sector. The report is based on surveys responses from executives inside approximately 85%-90% of China's most important factories. A Markit flash score above 50 means that activity is expanding and a score below 50 means that activity is contracting. Although the final reports are not published for another two weeks, the Markit flash reports seldom differ from the final reports.

The Chinese Lunar New Year festival began this year on January 31 and most workers tend to go on vacation for two weeks back to their family homes. Consequently, economic activity during the Lunar holidays is an excellent indicator of the pace of domestic consumer demand. The purchasing managers' index falling from a weak 49.5 in January to a seven-month low of 48.3 in February is a strong indication the accelerating contraction in demand is being driven by weak domestic consumption.

Former Chinese President Hu Jintao and Premier Wen Jiabao in 2010 published "Report on the Work of the Government" and report of the National Development and Reform Council (NDRC) that formed the basis of China's Five Year Plan (2011-2015) to discard the economic model followed for the past three decades of emphasizing export manufacturing and to focus the nation's economic and development efforts into building a modern consumer economy. The main features of the new policy orientation were: converting China from being the "world's manufacturer" to becoming the "world's consumer"; upgrading its scientific and technological capabilities with an emphasis on innovation; expanding educational coverage; and improving the living conditions and increasing the wages of the people, especially those in the rural areas.

Over the next five years, China's leadership encouraged "new measures" that included widespread property tax changes that released huge amounts of agricultural land for housing development. State-owned-banks were commanded to increase lending in just five years by $15 trillion, twice the entire Chinese annual gross domestic product (GDP). As a result, housing prices increased in major cities like Beijing from an average of $1,150 per square meter in 2005 to $11,400 per square meter today. Condos that would have sold for $3,500 in 1994 are now listed for sale at $833,000.

Over the last six months, real estate demand and prices have been contracting faster in cities beyond the nation's relatively wealthy "first-tier" metropolises of Beijing and Shanghai. According to the Securities Times newspaper, housing developers in the industrial city of Hangzhou cut prices this week by an average 19% in a scramble to sell about 120,000 newly-built apartments. The current inventory of new, unsold units now exceeds the total number of housing units offered for sale in Beijing and Shanghai combined. A study by Shanghai's Tongji University said real estate has been especially shaky in the northeastern city of Wenzhou, where new-home prices have fallen every month for the last two years.

The borrowing binge in China was not just restricted to state-owned lenders; approximately $3.5 trillion in private loans made to individual speculators at up to three times the interest cost of bank borrowing. Many of these loans were made to shady business operators who bought coal mines to speculate on the growth of electricity demand. But most of those loans became insolvent as the economic slowdown caused the price of coal to be cut in half over the last year.

Chinese banks over the last six months have been forced to borrow large amounts of short-term money as income from their loan payments have slowed. The Sunday edition of London's Daily Telegraph published a story that, "Currency crisis at Chinese banks could trigger global meltdown". The article warned that short-term foreign currency borrowing by Chinese companies has almost quadrupled in just four years to more than $1 trillion. "Any substantial appreciation of the U.S. dollar -- and many analysts are indeed expecting gains this year -- could open up a dangerous cross-currency mismatch, forcing Chinese borrowers to default and inflicting shattering losses on international lenders."

According to Beijing's State Administration of Foreign Exchange, at the end of 2013 China had foreign liabilities of a stunning $3.85 trillion; roughly 40% of total GDP. The bulk of those liabilities consist of $2.32 trillion of highly illiquid foreign direct investment for plant and equipment. Another $374 billion is foreign investments in China's stock and bond markets that could be sold at any time. But most investors are unaware that money is also locked up because China's qualified foreign institutional investor program has strict limits on the size and frequency on withdrawing money from country.

The contraction of HSBC/Markit Purchasing Managers' Index to 48.3 during China's biggest annual holiday seems dire when coupled with the PMI's Employment Index fall for a fourth month in a row to 46.9, its lowest point since the depth of the financial crisis in February 2009. Over the last five years, Chinese central planners drove GDP per capita from $2,204 to $3,348, the fastest expansion of any large economy in the world.

Communist party leadership would obviously like to continue to inflate China's economic bubble with more lending. But with banks facing massive loan losses and scrambling for short-term funding just to survive, central-planners seem powerless to prevent China's economic bubble from bursting.

The author welcomes feedback mailto:chriss@chrissstreetandcompany.com Chriss Street is teaching microeconomics at University of California, Irvine this spring from March 31 - June 8, 2014. Call Student Services at (949) 824-5414 or visit http://unex.uci.edu/courses to enroll!