China is widely seen as the saviour of global economic growth.

So whenever it reports on how its economy is doing, analysts around the planet take careful notice.

And despite ongoing fears that China will one day give us all a nasty shock, none has materialised so far.

Yesterday looked like more of the same: there was nothing remarkable about the latest batch of data.

That is, until you drill down into the details. Then you start to realise why China could be the worlds next big economic worry.

China has a serious inflation problem

Its almost impossible to imagine Britains factories churning out 13.3% more output this year than in 2010. In fact, Britains industrial production is currently shrinking.

But in China, double-digit rates of growth have become the norm. Even at its worst the end of 2008, at the nadir of the Great Recession industrial production growth didnt dip below 5% year-on-year. And within 12 months it had rebounded to a stunning 20%.

Last month, the figure clocked in at 13.3%. That was down a tad from Aprils 13.4%. But it leaves the countrys economy on track for stable and relatively fast growth, says Sheng Laiyun from Chinas National Bureau of Statistics.

So nothing to worry about, then? We can rely on China to just produce more and more goods that Western consumers will buy until their credit cards are maxed out (again)?

Actually, no. We cant. Because China has a serious problem, that gets worse as each month goes by. The cost of living is getting out of control. Even the official figures show consumer prices climbing at a 5.5% annual rate. Thats a 34-month high. Unofficial estimates of how inflation are much higher.

Yesterday stock markets seemed relieved that the news wasnt any worse. But investors shouldnt feel complacent.

Chinas central bank may be too late to stop inflation

The Chinese authorities arent likely to admit how much theyre worried about soaring inflation. But they know theres a risk of it stirring up social unrest. And they wont want that – it can spread fast, as weve seen from North Africa and the Middle East this year.

So just watch what theyre doing. 12-month interest rates have already been jacked up four times to 6.3%. Minimum deposits for second homes have been raised, and property taxes brought in.

On top of that, orders went out to lenders yesterday to set aside record amounts of cash at the Chinese central bank as reserves. That means this money can no longer be lent out. The idea is to curb both economic growth and also inflation pressures.

Unfortunately, the Chinese central bank may already be too late to stop inflation from becoming a very damaging problem.

The Chinese money supply – how much cash is slopping round the system – is still increasing at 15% a year. That suggests theres more inflation to come.

Further, despite those interest rate hikes, Chinas housing market is still going nuts. The number of housing transactions is up 18% on last year. If the property bubble continues to inflate, that will drive the cost of living even higher.

In short, Chinas central bank is walking a tightrope. It might not tighten monetary policy enough to have an impact on inflation, in which case it would have to crack down even harder and faster later. Or it could panic and impose over-heavy credit controls, which would crush the economy anyway.

Whats the bottom line for investors? Clearly the risks of something going wrong in China are rising. And a major Chinese economic slowdown – whenever it happens would send huge shockwaves through the worlds stock markets.

Sell cyclicals, buy defensives

What effect will this have? Over the last two years, cyclical stocks which rely heavily on expanding economies for their profits have been all the rage with investors. But much slower Chinese expansion would change this.

Cyclicals would become yesterdays story. Instead, defensive stocks that dont need economic growth to make their money, and which have been largely out of favour, would return to the spotlight.

So what to buy? In Money Morning, weve tipped a number of high-yielding defensive stocks with inflation-busting dividend increases to protect your portfolio. Several of these are here in the UK.

As we pointed out earlier this week. food retailer J Sainsbury (LSE: SBRY) is a classic case in point. Well be looking at this mornings results in more detail later. But on a p/e below 12 and near 5% yield, it looks to be a stock worth holding.

On a wider view, in ths weeks MoneyWeek magazine cover story, James Ferguson takes a detailed look at Chinas looming slowdown. Whats more, weve got several ideas about how to take advantage. If youd like to become a subscriber, you can get your first three issues free, plus more information on how to protect your portfolio from inflation, here .

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