How a debt meltdown in China could wreck Australian share prices

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China has been back in the media recently – and for all the wrong reasons. Debt fears are once again worrying investors, with China’s total debt being estimated at around 250% of its total GDP. McKinsey Global Institute estimated it could be as high as 282% back in February 2015.

This level of debt is higher than the USA and an area of Asia had before their respective financial crises, and has grown by more than 100 percentage points since 2007, suggesting that most of China’s growth has been fuelled by debt.

Why should I care?

Many Australian public companies have direct or indirect exposure to China. The miners are in the worst position, with minerals and petroleum making up 6 out of our 10 largest exports. Around 35% of our total exports head to China. Companies like Rio Tinto Limited (ASX: RIO)BHP Billiton Limited (ASX: BHP) and Fortescue Metals Group Limited (ASX: FMG) are thus heavily exposed to any reversal in China’s fortunes.

We’ve already seen a stark decline in the North Queensland, Western Australian, and Northern Territory economies just from lower resource prices. There is potential for the Australian economy to deteriorate significantly if demand for iron ore and coal dries up.

Multiple ways to win lose?

There’s two major ways that China could go wrong. One is that the real estate sector collapses – since approximately half of all lending is reportedly linked to this sector. There are numerous media reports about ‘ghost’ towns full of empty houses and idle cranes. In addition heavily indebted corporations could fail to make debt repayments. Either occurrence could force a costly government bailout.

The second is China’s stock market, which was partly opened up to household investors and subsequently skyrocketed as it was fuelled by huge margin loans. The market’s subsequent tumble was well publicised last year and continued despite a number of measures – including outright selling bans and concerted buying that failed to stabilise it. Margin loans are a concern because they can lead to investors losing all of their capital and having large debts if the market turns.

With such a small middle class, a property or margin lending bust could easily hurt the country’s demand for Australian goods for years into the future. With companies like Blackmores Limited (ASX: BKL) and Bellamy’s Australia Ltd (ASX: BAL) seeing significant potential in China, a collapse in consumer spending carries significant risks for them too.

A whole pile of other companies including, but not limited to, SEEK Limited (ASX: SEK), Goodman Group (ASX: GMG), Graincorp Ltd (ASX: GNC), Australian Agricultural Company Ltd (ASX: AAC), and Treasury Wine Estates Ltd (ASX: TWE) have exposure to China – and let’s not get started on Chinese demand for Australian companies and property.

It’s very easy to see both the significant risks and the sizeable downside that could come from economic weakness in China.

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Motley Fool contributor Sean O'Neill has no position in any stocks mentioned. The Motley Fool Australia owns shares of Bellamy's Australia. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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