China's Shanghai Index rallied 90% since November 2008 supported by the Chinese government's massive stimulus plan and a record expansion of bank lending. The Chinese government stimulus plan totaled $586 bln and was adopted to ensure the Chinese economy would grow by 8% in 2009.The Chinese central bank pumped a record amount of liquidity into China's markets as well to try and boost GDP growth.  The Shanghai Index recently experienced significant selling pressure and the stock market decline generates concern about China's economic recovery.  In early August, the Chinese government announced a plan to curb lending, cap steel production and reduce overcapacity. The Shanghai Index declined 22% in August pressured by concern that the plan to cap lending and reduce overcapacity could choke off the Chinese recovery.

The Shanghai Index dropped 6.7% Monday and many analysts suggest that the Shanghai Index has entered a bear market. The Shanghai Index is vulnerable to concern that slower lending will hurt Chinese growth. According to Bloomberg, a former Asian economist with Morgan Stanley, Xie, predicts that the Shanghai Index will fall another 25% because of concern about China's economic outlook. Xie says the Chinese economic recovery is unsustainable and the recent economic recovery was fueled by government stimulus not a change in fundamentals. Not all analysts agree with Xie. Economists at Goldman Sachs have raised their growth forecast for China to 9.4% in 2009 from an original estimate of 8.3%. Goldman Sachs sees potential that China's GDP could increase by 11.9% in 2010. Last month, China's Premier tried reassure the markets and said that the government will continue with stimulus and easy credit to fuel growth. Part of the rationale for the Goldman Sachs upgrade of China's GDP outlook is that the Chinese government has limited room to tighten credit and raise interest rates. The government clamp down on growth therefore should be limited.

China's manufacturing economy continued to expand in August

Asian markets posted a modest rebound Tuesday supported by report of continued rise in China's manufacturing PMI in August. China's August Manufacturing PMI came in at 54, beating the July reading of 53.3. China's manufacturing PMI rose at the fastest rate this year in August and has risen for the last six months. A reading above 50 means that the Chinese economy continues to expand. New orders, imports and employment all posted gains in August .The PMI report suggests that the Chinese recovery remains on track and the Shanghai Index decline may not reflect this fact. The price movements of the Shanghai Index are often driven by speculation. This makes a number of analysts' question why investors are so sensitive to the movements of the Shanghai Index. The fact of matter is that of late global equity, financial markets and FX trade have been closely tracking the Shanghai Index trying to gauge what the recent selloff in the index means for the global recovery.

The major question facing China's economy is how much liquidity will be taken away by the government and if this will contribute to a major slowdown in manufacturing output into year end. The direction of the Shanghai Index will be key to the outlook for risk sentiment and in particular for the direction of global growth linked currencies like the AUD and CAD. Based on today's PMI report from China, investors may want to reassess fears about the outlook for China's and the global recovery but, if the Shanghai Index continues to slide it may take the global markets and the recovery with it.