China Won't Bail on Europe, But World Economy Still Looks Dim

The reality of the European debt crisis should be terrifying enough for investors. But a constant barrage of quickly debunked rumors and speculation have served to fray nerves even further.

The latest chapter of the now familiar pattern came on Thursday, when China vigorously denied reports that it was rethinking the viability of its investments in eurozone bonds. "Europe has been and will be one of the major markets for investing China's exchange reserves," the State Administration of Foreign Exchange posted on its website.

Markets around the world and the euro rallied sharply amid the reassurance by China, which holds $2.5 trillion in reserves. But despite all the crying wolf, investors should not lose sight of the developing dangers in both China and Europe amid the mood swing.

Chinese Economy Fraught with Peril

The Chinese economy is expanding at double-digit rates, but it is fraught with peril despite the growth. Soaring property prices amid a housing bubble led Beijing to embark on a series of maneuvers to tamp down growth. And those policies, including more stringent bank lending, higher mortgage rates and bigger deposits for often-speculative second homes, seem to have had the desired effect.

Apartment sales dropped by 53% and 64% in Beijing and Shanghai respectively in the first two months of May compared to April. But the pricking has stoked fears of a dramatic slowdown and hard landing for the economy. Chinese stocks, hammered and more than 20% off their recent peaks are now trading in a bear market.

Investors are rightly recalling a similar sharp slowdown in the overall Chinese economy after Beijing put the breaks on the housing market in 2007. Long seen as an engine of growth amid lackluster worldwide demand, then, the Chinese economy now also shows signs of blowing a piston.

Outlook Hardly Rosy In Other Major Economies

And as the US stock market stages a rebound from technically oversold conditions, investors should note that developments are hardly rosy in the world's other major economies.

Despite sings of an economic rebound, many overly indebted European countries now face sharp austerity measures like budget cuts and rising taxes. Those are likely to hit demand and growth at a precarious moment. Calls for demand generating stimulus spending on the part of the reluctant Germans are rising.

The sliding euro, ironically, may be a saving grace in the equation despite causing so much consternation for investors. The slide to current levels will boost eurozone GDP by about 1% according to calculations by Credit Suisse.

Investors have wrongly interpreted the drop in the euro as just a referendum on the European economy. And fears over its demise are vastly overblown. Rather than simply setting the pace for world markets, the euro has become an indicator of risk appetite as well.

Will Europe's Gain Be At the Expense of the U.S.?

Despite the constant machinations, current levels simply reflect a correction of the euphoria and run up that followed in the wake of perceived Chinese intentions to diversify beyond dollar denominated assets.

But much of Europe's gain might come at the expense of the United States. As the dollar climbs, American goods become less competitive in increasingly important export markets.

And the United States could use the boost as recent data show. GDP growth for the first quarter was revised down to 3% on Thursday. That is hardly the kind of sharp recovery that many investors have been anticipating in the wake of a steep recession.

World markets may be breathing a collective sigh of relief following the debunking of China's potentially calamitous intentions. But the reality of the world economy is hardly inspiring, either.