The Chinese economy may be in trouble and the stock market seems to acknowledge the dangers.

As many China bears have previously warned, China’s blistering growth over the last two years were based on massive government stimulus and unconstrained lending from banks. The end result was over-investment in infrastructure and over-construction in buildings, which did not bear fruit for the money spent and offers only a shaky foundation for further economic growth

Moreover, inflation began to accelerate, forcing the Chinese government to curb lending and raise interest rates. In fact, the tightening efforts of the Chinese government in 2011 has taken the lending rate close to 1 percentage point of pre-recession levels and the bank reserve requirement ratio for large banks to an all-time high of 20.5 percent.

The fear is that if China’s growth has been fueled by rampant lending, the slowing down of lending may therefore crash the economy, or at least slow it down. Furthermore, the construction of commercially unviable buildings, many of which remain empty, is economically unsustainable and must stop sooner or later.

The main problem for the Chinese economy is the failure to distribute income to its massive population and cultivate consumption. Before the financial crisis, the Chinese economy relied on exports to the US. In the past two years, it has been fueled by over-investment and over-building.

Investors in the Chinese stock market may have already wised up to the dangers facing the Chinese economy as the Shanghai Composite has steadily declined since late 2009.

The first chart below compares its performance with the stock indices of the US, South Korea, and Brazil. The second chart below shows how the stimulus package-induced rally of the Shanghai Composite fizzled out in less than one year.

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