What China's Stagnating Economy Means for the World

Crunch! That's the sound of China's manufacturing sector as the slowdown intensifies in the world's second-largest economy. The country's once-powerhouse economic growth has slowed from a double-digit percentage rise just a few years ago to growth of less than 8% projected for this year, and manufacturing has fallen right alongside that number. HSBC's Flash Purchasing Managers Index for China, showing the health of the manufacturing industry nationwide, declined to 48.3 in June, dropping nearly a full point from May's reading and now solidly in contraction territory.

A massive credit crunch in the country is exacerbating manufacturing's problems, as lending dries up in China's financial sector and companies turn to Hong Kong for cash. In response, Hong Kong's interest rates have skyrocketed. Is China's amazing growth story finally on its last legs -- and more importantly, what does this worsening decline mean for the rest of the world as America tries to continue its nascent recovery and Europe looks to dig out of recession?

What the crisis means to China
Danger, China and emerging-markets investors: While many have pointed out the upside of emerging markets -- myself included -- China's cash crunch isn't restricted to just China. Nearly $4 trillion of cash has flowed into developing nations over the past four years, according to BloombergBusinessweek, but a stronger dollar buoyed by the likely tapering of U.S. quantitative easing, along with weaker emerging-market economies, could see cash inflows and investments in emerging economies wane. Already, cash inflows in China were reported in June to increase by the smallest amount since last November.

That's helped destroy the iShares MSCI Emerging Markets Index fund , which has lost a crushing 15% over the past month alone. China's right in the forefront of this decline, and Chinese ETFs have been hammered just as badly: The SPDR S&P ChinaETF has lost more than 13% in the past month and is down more than 17% in 2013. Forget about keeping up with the market; emerging-markets-oriented investors haven't even been able to break even this year.

Beijing has been reluctant to launch wide-scale monetary easing, preferring instead to focus on financial reform to clean up bad lending policies among Chinese banks with limited availability of funds to lenders. While that's a smart policy for the long term, it's a critical blow in the short term that could slow China's growth even further. With funding elusive on the Chinese mainland, companies have turned to Hong Kong for cash. Hong Kong's interest rates have jumped because of the unforeseen demand, and borrowing costs for Chinese companies have soared as a result.

China's companies now have even less wiggle room to operate, considering lending's either expensive or hard to come by. As investment flows out of the country, unstable companies won't survive, even with government support. Solar-power company SuntechPower's recent bankruptcy is an early sign of things to come. Suntech was the first Chinese solar-power company to go public when it hit the market in 2005, and generous public subsidies helped propel its growth. With money tightening across the country, Suntech's questionable business practices sank it -- the first of what could be more troubles to come for weaker Chinese company.

Unfortunately for China, any wide-scale stimulus to solve the problem may only exacerbate the Chinese economy's worries even more. The Federal Reserve's likely tapering of quantitative easing this year should strengthen the dollar, making investment in the U.S. more attractive and hastening the pace of capital outflow from China. Weakening the Chinese yuan would heighten the outflow, reducing investment in China further. Beijing won't let its economy slump without any action at all, but don't expect the kind of drastic stimulus actions that the U.S. and Japan have popularized.

More than ever, investors in China need to watch out for the very best businesses to buy stock in. Suntech's troubles and the money crunch are sure signs that questionable business are on borrowed time.

How will the West fare?
China's manufacturing slump isn't what Europe needed to hear about. China is the European Union's largest export source, but the manufacturing slump will cut into the sector's demand. That's not good for leading European materials and industrials companies, particularly as machinery and transportation equipment make up some of the EU's largest export categories to China. A brewing trade spat between the two blocs isn't helping, and a few industries have even more to worry about.

Beijing's subsidies to domestic materials producers has made life tough for leading companies in the industry, such as the world's top steelmaker, Europe's ArcelorMittal . Unless China counters its slowdown by increasing infrastructure investment -- an action the government has taken before -- Chinese oversupply could hamper already-pressured prices in steel and other commodities even further. Slowing demand has hurt ArcelorMittal and its rivals in the industry already, and a glut of supply in what is still one of the world's fastest-growing economies won't help sales get back on track.

In short, don't expect exports and trade to get Europe back on track with China's manufacturing sector in contraction.

What's bad for Europe could be great for the U.S., however. America's economy isn't anywhere near as reliant on China as a trade partner as Europe is, and the dollar's strength behind the likely coming end of quantitative easing will benefit on the back of China's cash outflow. That's a big boost for the American economy at a crucial point in its recovery as the Federal Reserve backs off its stimulus. Cash inflow from China and other slowing emerging economies effectively could continue the benefits of easing without any central bank action, fueling the next few years of growth for the United States.

While the U.S. economy is sitting pretty as China slows, things aren't so black-and-white for American companies. Leading manufacturers such as Caterpillar have seen China as a major opportunity for growth in future years on the back of the country's previous growth. While the U.S. rebound and housing recovery should help Caterpillar, a major Chinese infrastructure investment would have propelled this company -- and the industrial sector as a whole -- back up the charts. That obviously won't happen if China's economy keeps falling and its manufacturing sector continues to be mired in contraction territory.

Use caution around the mining sector in particular, which Caterpillar produces equipment for. With an oversupply of materials, reduced investment, and greater cash outflow, mining companies and equipment manufacturers relying on China to power the future will be in for a rude awakening. Australia's mining sector has already cratered with China's slowdown, and a wider contraction in this industry could be just over the horizon. U.S. growth won't be enough to save miners and equipment manufacturers from a greater slowdown in China and other emerging markets.

Tough times ahead for China
All isn't lost in China, and the world's second-largest economy won't destroy the fragile global recovery all on its own. However, investors thinking about buying stock in companies counting on China for growth -- or in Chinese companies themselves -- need to be judicious about their picks. While sturdy, reliable companies such as Caterpillar can withstand a Chinese slump, riskier plays dependent on China may be at the end of their line. China's slowdown reinforces a trusty maxim for long-term investors everywhere: Stick to the fundamentals and buy into great businesses.

With the American markets reaching new highs, investors and pundits alike are skeptical about future growth. They shouldn't be. Many global regions are still stuck in neutral, and their resurgence could result in windfall profits for select companies. A recent Motley Fool report, "3 Strong Buys for a Global Economic Recovery," outlines three companies that could take off when the global economy gains steam. Click here to read the full report!

The article What China's Stagnating Economy Means for the World originally appeared on Fool.com.

Fool contributor Dan Carroll has no position in any stocks mentioned. The Motley Fool owns shares of ArcelorMittal. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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