Almost three months ago in our posts The Lull Before The Storm and The Return of The Stress we predicted a new acute crisis phase in Europe centered around insolvency fears for banking systems and sovereign debt. It appears this phase has begun, with news headlines such as Ireland’s Woes May Spread on ‘Zero Confidence,’ Lloyds Says, Spain, Portugal Bank Debt Risk Soars as Traders Look South, Spain Banks Face Debt Challenge as ECB Cuts Cash, Moody’s Says and even blog posts with titles such as Euro Area Disintegration Watch – November 23.

With fireworks of such magnitude so close to home in the Eurozone, it is all too easy to forget two other powerful sources of gravity-defying Ponzi-like instability: China and Japan.

In an important edition of John Mauldin’s Outside the Box newsletter titled “Shadow Over Asia“, there are some eye-popping facts:

* New lending in China in 2009, force-fed to state controlled enterprises, amounted to 29% of GDP, hence the massive inflation and investment in unproductive capital (see below)
* The South China Mall, second largest in the world, is mostly empty
* China built an entire city for 1.5 million people, Ordos in Inner Mongolia which is completely empty
* Property-value-to-income ratios in Beijing are 14x and in Shanghai 12x. At the peak of Japan’s massive housing bubble, this ratio for Tokyo was 9x
* There are 64 million vacant apartments in China and property investments rose to 10% of GDP in 2009 whereas in Japan’s pre-bubble peak property was 9% of GDP, and in the US it never exceeded 6%
* Refined copper imports by China in August 2010 were up more than 22% relative to the year before. Much of it wasted in unproductive investments such as the above.

The Chinese government can keep their bubble going for quite some time, at the expense of a much harder landing when they eventually fall victim to either a collapse in the value of their currency (if they don’t ease off their centrally directed unsustainable capital spending) or debt deflation (if they do). Either way, a hard landing is in the cards for China. The only question is when.

As for Japan, it too is a ticking time-bomb. The explosive material is the government debt at 200%+ of GDP, a normally unsurvivable level which has not yet caused an Irish- or Greek- style crisis because deflation-mired Japan currently borrows at 1.4% from its own citizens who have well-anchored deflationary expectations. The burning fuse in this bomb is the fact that Japan’s population is aging and there is no immigration into Japan, and as a result the legendary Japanese savings rate has fallen from double digits to almost zero, as the proportion of population over the age of 65 has now passed 25%. With insufficient new domestic savings to bid up the prices and hold down the yields for new issues of Japanese government bonds, these new bonds will have to be sold outside Japan. The bond markets will surely not lend to Japan at a discount to Germany, so yields will have to explode upwards the minute Japan tries to borrow abroad! For perspective, if the interest rate Japan has to pay doubles to say 2.8%, the additional interest is equal to the entire budgets of their departments of Defense and Education. Thus the end of the road for a long-standing Ponzi scheme in Japanese sovereign debt is also drawing near. Japan is poised to go from deflation to a collapse in the value of its currency without passing “GO” and without collecting its $200.

The U.S. wants China to reduce its trade surplus and let its currency appreciate so that it can solve its own problems. Europe wants to do more business with China. China could recapitalize the IMF, which would then be in a position to bail out Spain when and if Germany balks at doing so. Japan could cast aside thousands of years of history, and open its borders to Chinese migrants to postpone its own fiscal doomsday. As global problems continue to mount, nations teetering on the brink of insolvency or deflation – large and small – look towards China for solutions. But China has its own problems, far more than it permits the world to see, and so China cannot possibly be the solution that everyone appears to have pinned their hopes on. And so the global Jenga Block Tower is rising higher and higher. Contagion from the impending spectacular collapse of the EuroJenga Blocks Tower is highly unlikely to stop at Europe’s borders.