A couple of weeks ago I’d originally started my column by indicating my call for a second-half downturn might be wrong. But then the June jobs report hit, and I hit the delete key on that intro. It’s now mid-July, and despite the lackluster jobs climate and Europe’s troubles, the strong start to earnings season has fueled a market rally. I’m sticking by my first call, but perhaps I should have saved those paragraphs.

Here’s how I see the second half unfolding: Employment and consumer spending remain weak. Europe’s troubles mount. China’s growth slows.

The first is a given, but Europe is a question mark. Ultimately it won’t avoid its day of reckoning, but it could string its debt problem out long enough to diminish the pain. That’s the hope, and if they’re successful, Europe may not cause a global economic slowdown.

Regardless, it’s all about China – which is also a question mark. If China’s economy slows, the world economy will slow. To check inflation, the Chinese government has continued to tighten. Though that’s the right course, it should result in slower growth.

HSBC’s preliminary survey of manufacturing indicates China’s manufacturing base may have contracted in July. If the preliminary number holds, it would be first contraction since June 2010. A single data point does not make a trend. China’s purchasing managers index, or PMI, exhibited a similar trend last July. That brief dip into contraction was followed by several months of expansion.

However, although continuing to expand, China’s manufacturing sector has been sliding consistently downward since late 2010. The next couple of months will be telling. If the slide continues China’s economy may be heading for a soft patch.

But more alarming than China’s manufacturing sector is the potential popping of its own real estate bubble. If that happens, it will absolutely trigger a global hiccough. But will it occur? And if so, how bad will it be?

Because it’s difficult to validate the veracity of the data coming from China no one can know for certain. Moreover, unlike in the United States, where the housing decline was predictable, China’s real estate dynamics differ in key ways.

As in the U.S., Chinese real estate values have ballooned to what could be considered unrealistic levels. Also as in the United States, those values have begun to decline. But unlike the United States, China hasn’t allowed absurd pay-me-later loans. Also unlike the United States, China requires homebuyers to pony up a substantial amount of equity.

Unfortunately – again like the U.S. – China’s government artificially juiced the real estate market. In their case, much of its economic stimulus in 2009 and 2010 landed in land purchases causing prices to escalate “unnaturally.” (As Freddie, Fannie Mae and subprime loans did in the U.S.)

But unlike here, there are limited investment choices in China. And their state-controlled banks offer interest rates below the rate of inflation. Consequently, real estate is the favored investment for average citizens with cash.

According to some experts, over the last four years investment in residential property has increased to about 9 percent of China’s gross domestic product. This influx of cash has caused prices to roughly double in China’s major cities.

Because of the lack of investment vehicles, and the reliance of local governments on land sales for revenue, it’s possible real estate prices will continue to rise for several more years. If they do, it will only make the eventual collapse worse. The only good news is that the ensuring body blow to the world’s economy will be postponed.

Famous short-seller Jim Chanos doesn’t think it will take several years. He’s been calling for a housing crash for the last two years. Predicting the eventual outcome is the easy part. What’s hard is getting the timing right.

A number of things could act as a catalyst for a crash. Interest rates could rise to untenable levels. Other investment opportunities could emerge and siphon money away from real estate. Or China’s newly instituted property taxes could make investing in real estate too risky for the reward.

As with the United States, the question isn’t whether China’s housing will correct, but how severe it will be? Like here, China’s real estate market directly impacts the construction, steel, power, and appliance industries. According to Standard Chartered economist Stephen Green, about 50 percent of China’s GDP is linked to real estate. Even if the actual percentage is a third of Mr. Green’s estimate, a correction would be ugly.

The critical unknown is the amount of leverage that exists in China’s real estate. It wasn’t only the price downturn that hurt us but the fact that buyers were highly leveraged. That leverage in turn forced the sharp increase in defaults and foreclosures.

Given the secrecy that surrounds the Chinese government, determining the level of leverage is impossible. What is known is that to counter the global downturn, state-owned banks were instructed to lend about $3 trillion to state-owned enterprises. That money funded infrastructure projects, but some portion of it also financed real estate purchases. The question again is how much?

Keep an eye on China’s real estate market because it holds the key to causing a global rough patch.

Author, professor, entrepreneur, radio and TV commentator, Tony Paradiso can be reached at tparadiso@tds.net.

Newsletter