Goldman underestimates huge potential downside for Chinese stocks Down by more than 10 per cent since recent highs Chinese stocks could drop by another five to 10 per cent in the view of Goldman Sachs, the firm which got the commodities sell-off right. But there is no consideration of a more extreme scenario that ArabianMoney considers more probable. The immediate cause of further decline will be slowing GDP growth and higher inflation, the latter partly responsible for the former. However, there is considerable debate among analysts about the internal stability of the Chinese economy and its ability to withstand a slowdown. Fundamentally solid Those who say China is â€˜fundamentally solidâ€™ remind this correspondent of HSBCâ€™s chairman John Bond who dismissed fears of the US economy in 2006 as â€˜completely wrongâ€™, while in the event it was Mr Bond who was completely wrong. Could it be that the Chinese economy which injected the largest stimulus package in history after the global financial crisis is â€˜fundamentally solidâ€™? Can a country where more than half of GDP comes from construction and real estate be considered â€˜fundamentally solidâ€™ and not over-heating and over-leveraged? Time will tell. So far the growth rates have been so impressive that the bears are easily silenced. Hedge fund manager Jim Chanos sees China as â€˜Dubai 1,000â€² in terms of a property bubble. His reckoning is that such a bubble has never unwound in history without a crash. In Dubai too we once argued it would never happen here! Why then is Goldman so timid in its scenario for stocks? It is surely an over estimation of the omnipotence of the Chinese government. Thus far China has raised reserve requirements at the banks 11 times and upped interest rates four times to cool inflation now at 5.3 per cent. Bounce back? Strangely Goldman has property and banks as its top stock picks but is underweight on industrials, steel and aluminum. The US bank is expecting a rebound after this correction phase is done. What will drive it? QE3 does not exist. The Chinese stimulus is inflationary. The bank does not even dare posit a more extreme scenario, the kind of â€™sudden stopâ€™ we saw in Dubai three years ago this October. Yet if you really step back and look at the long boom in China, and its over-extension into real estate and construction, then this just has to be the most probable conclusion. It would mean a 50-80 per cent wipe out scenario for Chinese stocks, at least in relation to recent highs. This is hardly impossible. It happened in Hong Kong between 1997 and 2003, and then indeed there was a recovery. Dubai stocks are still 70 per cent down.