Starting January 26th, Chinese stocks in the Shanghai and Shenzen markets went on a slide that was given very little attention by financial media. I understand there is a pervasive belief that China’s economic growth is an unstoppable force and any pullback is likely to be downplayed or even hyped as a great buying opportunity. In fact, this week both the Shanghai and Shenzen indices staged a rebound so it may appear that all is well. While that may be true, we must pay very close attention. When Thailand had their coup last year and then played around with foreign investment rules, we saw a very quick negative response but that’s as far as it went. It seems to me that a secondary Asian economy like Thailand, Malaysia, Korea, Indonesia, etc. doesn’t have what it takes to set off a cascade of Asian contagion like they did in 1997. The Asian economies, currencies, central banks, and markets have evolved to very competent levels since the end of the 90’s. However, the real danger here is that most of the Asian countries have become heavily dependent upon Chinese growth and have created economies that are largely export driven. So while the secondary players in Asia are relatively strong and resilient, that only lasts as long as China grows at a pace that sustains their economies.

If China’s growth slows too quickly or hits insufficient levels, the effect on US markets will be tough to avoid. I am not speculating about whether this will happen, but when and to what extent. Just consider this comment from Han Yongwen, secretary-general of the National Development and Reform Commission - “Economic development is moving in the expected direction but GDP growth in 2006 was a bit too high and we want it to slow to a reasonable growth rate (this year).” Han didn’t give a forecast for 2007 GDP growth but said it will be set at the National People’s Congress which will be held in early March. The economy grew 10.7% last year and represents close to one-third of total global economic growth. So as much as we stay conceitedly focused on our soft landing in the US, maybe its really in the hands of a Chinese Goldilocks.

For the last several years, US investors have become enamored with international investing, and specifically China and the emerging markets. It has worked out well to this point and may continue, but a slower growth rate managed by the Chinese government should not be ignored. In the past week, financial media has given some attention to the risk in Chinese stocks and the Financial Times went so far as questioning whether it is a bubble. Once again we can attribute the concerns not to speculation, but direct comments from Chinese officials who are blatantly signaling their intentions to rein in the economy and the markets. On January 31st, Cheng Siwei, vice-chairman of the National People’s Congress and an influential figure in Chinese finance, said that only 30% of stocks on the Shanghai Stock Exchange were “good to invest in by western standards.” He said the other 70% would probably lose money. The markets held in despite those comments but it is something to consider.

If you have capital at risk with Chinese and emerging market stocks, keep a very close eye on these factors. When the growth slows in China this year, I’ll be hoping it doesn’t spur a new Asian contagion.