First cracks begin to appear in the Chinese economic boom

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At trader haunts in Beijing and Shanghai, the usual chatter is of the overheating economy, of double-digit growth and how China will function as the economic engine of the world during a slowdown. No one mentions the dreaded word sub-prime over cocktails at Centro or "M on the Bund".

But, while Asia is still expected to be the world's top-performing economic region, the focus is increasingly on how China weathers what looks like its first storm. The spillover from the sub-prime investment downturn appears to be hurting even China and the country is gearing up for the first significant hurdle in two decades of breakneck growth.

In line with the global sell-off, Shanghai's stock index lost 7 per cent yesterday, a reversal which will shock a new generation of millions of investors who have never seen a market fall. It is this shock that has rattled the government because of the possible effects on social stability.

"Two of the three stocks I hold fell sharply today... 5,000 yuan (£354) disappeared in a few days. I just want to cry. I want to tell everybody I know: keep away from the stock market," said one new investor, Dai Yu.

Another, Yi Ran, said: "Tomorrow is a day fraught with grim possibilities."

The declines come at a time of rising inflation, which is causing concern on the streets. Consumer price inflation hit an 11-year high of 6.9 per cent in November – and ordinary Chinese are upset by its effect on the price of the staple meat, pork, and now the price of alcohol. Maotai and other fiery liquors, popular over Chinese New Year, are likely to rise in price before the end of the lunar year, early next month.

The Chinese economy has had double-digit growth for years and it is becoming difficult to remember a period when it was not simmering. The economy remains fundamentally sound, and likely to withstand a slowdown in the US, but nerves are frayed.

Markets are bracing themselves for when the country's second-biggest lender, Bank of China, feels the brunt of the sub-prime losses. It is due to record a multibillion-pound deficit on £4bn worth of US mortgage-backed securities investments.

Bank of China's Shanghai-listed A-shares were suspended from trading yesterday morning, pending an announcement. A statement from the Shanghai stock exchange was as terse as it was unsettling: "Bank of China failed to make a statement on an important event so trading in its shares will be suspended for all day on January 22."

The company's response was almost casual, giving nothing away. It said it was "not aware of any reasons" for the unusual movements in its share price. Unusual they were – its Hong Kong-listed H-shares fell 8.61 per cent yesterday, after losing 6.39 per cent on Monday. In Shanghai, the company's shares fell 4.14 per cent on Monday. The speculation was that the bank would write down $2.4bn (£1.23bn) for the fourth quarter of 2007 and an equal amount for this year.

Bank of China is the country's biggest owner of sub-prime mortgage securities. Back in October it said sub-prime accounted for just over 3 per cent of its total holdings and it had made provision for $473m (£242m) of potential writedowns.

Keeping confidence in the banking sector is vital for China's well-being. For many years, the sector has faced allegations that it had not made adequate bad-debt provisions. Analysts have said it was only a matter of time before sub-prime losses struck. That said, this setback has been a long time coming.

The China Banking Regulatory Commission said yesterday it was working on monitoring the country's five major banks for sub-prime losses on a monthly basis. Market sources say the regulators have warned all of the big banks they will have to cover any sub-prime losses.

The overall banking picture in China appears to be more upbeat. Four major banks have all announced expected net-profit rises of between 48 and 110 per cent. However, healthy bottom lines mask a deeper malaise, and all the top banks are expected to increase write-downs following fourth-quarter losses.