Nor is China an isolated case. In India, money supply grew at an annualized rate of 12.8% in the period that ended on March 4.

The cheap-money cycle has had powerful positive effects on global economies. For example, India's GDP grew by 7% in the fiscal year that ended in March 2005, after recording 8.5% growth in fiscal 2004. China's State Information Center projects that its economy will grow at an annualized 8.8% in the first quarter of 2005, after growing by 9.5% in the fourth quarter of 2004. By comparison, the U.S. economy grew at an annualized 3.8% in the fourth quarter of 2004.

Hard to pay the bills
Cheap money fueled an investment boom in everything from factories to telecommunications systems to make that growth possible. In China, the State Information Center projects, investment in fixed assets such as factories will grow by 24% in the first quarter of 2005 compared to the first quarter of 2004.

So what's the problem? Well, companies and individuals loaded up on goods because money was so cheap, and they will be hard-pressed to make payments when interest rates climb. The less developed a country's financial markets are, the larger the damage is likely to be in any shift from a cheap-money cycle to a less-cheap-money cycle.

In the U.S., where credit-card companies, banks and credit bureaus run sophisticated data collection and crunching operations, the turn is likely to produce a bump up in consumer defaults that will catch some badly run financial institutions by surprise. If the transition from one cycle to the other is abrupt enough, the result can even be the kind of massive default among financial institutions that characterized the savings-and-loan crisis of the late 1980s and early 1990s. That debacle cost U.S. taxpayers somewhere north of $300 billion.

Nor are corporate giants immune. When interest rates began to climb in 1993, companies as sophisticated as Procter & Gamble (PG, news, msgs) wound up losing millions on derivatives designed to offer financial insurance. (And don't forget the $1.5 billion in losses suffered by Orange County, Calif., at about the same time on its portfolio due to a derivatives package designed by Merrill Lynch (MER, news, msgs).)

China's debt crunch
The damage has the potential to be much worse in a country such as China, where the financial markets are still very much works in progress. Consider this example: According to the official Xinhua News Agency, China's local governments owe $50 billion (at official exchange rates), or about 15% of the country's total fiscal revenue in 2004. That figure is likely to be low, an official audit has concluded, but even that total exceeds the repayment capabilities of China's local governments. How did local governments get in such a fix when Chinese law prevents local governments from borrowing from banks? They evaded the law by borrowing from intermediaries set up specifically to secure bank loans for investments in local infrastructure.

Or this: China has put state-owned businesses on notice that within the next four years the central government will stop the practice of bailing out bankrupt companies, and companies that are technically bankrupt will actually have to file for bankruptcy. The government has closed some 3,400 state-owned businesses under existing transitional rules and estimates that an additional 1,800 state-owned businesses are now technically bankrupt and need to be closed. Most of these bankrupt businesses are owned by local and provincial governments that are already in hock, and they were financed by loans from state-owned banks run by local governments.

Nobody knows exactly how big the bad loan problem is. Nonperforming loans (a very subjective category in China) at Chinese banks total at least $200 billion. I say "at least" because a company owned by the People's Bank of China, the Chinese central bank, has injected $45 billion in capital into just two of the country's biggest banks, China Construction Bank and Bank of China, to clean up bad loans in preparation for an initial public offering and overseas stock-market listing for the two banks.

And finally this: Despite sometimes rudimentary risk-control systems, China's financial institutions are up to date in one area -- they're willing to play in the derivatives market with the big boys of Wall Street. Last November, China Aviation Oil, a jet-fuel importer listed on the Singapore market but backed by the Chinese government, sought protection from creditors after it ran up $500 million in losses in derivatives after betting that oil prices would fall. In China, just as in the U.S., nobody really knows the details of any financial institution's exposure to the derivatives market. In China, however, due to the immaturity of the financial system, it is much more difficult than in the U.S. to figure out where the risk in any derivative trade will actually come home to roost.

Fastest growth, biggest risks
All this creates a conundrum, to use Alan Greenspan's word de jour, for investors. The fastest economic growth in the global economy over the next decade -- possibly the only growth in the world economy outside the U.S. -- will take place in China and India.

At the same time, the biggest risks of either a major institutional crash or a financial- system crisis are to be found in the relatively underdeveloped financial markets of those countries.

The more abrupt the transition from a cheap-money to a less-cheap-money cycle -- and the faster interest rates rise -- the slower global economic growth in general. And, also, the higher the risk of a country-specific financial crisis in the financial markets of these key countries in the developing world.

Overseas investing strategy
I think there's a way around this problem that maximizes any investor's potential return from growth in these developing markets and minimizes that investor's potential exposure to a market-specific financial crisis. The key is to own the shares of companies that do business in China and India and that derive a substantial portion of their current revenues and future growth from those markets, but that are listed on financial markets that require reasonably transparent public financial reporting and that derive their capital from relatively mature capital markets. In other words, I think you get the most bang and the least bust by investing in China and India through stocks traded on the U.S. financial markets.

I think I've put together two basic rules for finding stocks that will do well in the post-cheap-money global economy:
Tips for Investors
Buy the stocks of companies that generate lots of cheap cash internally.
Buy the stocks of companies with substantial exposure to economic growth in the developing markets of China and India but without exposure to the risks to those immature financial markets.

Source http://moneycentral.msn.com/content/P111800.asp by Jim Jubak

E-mail Jim Jubak at jjmail@microsoft.com.