In The Hobbit by J.R.R. Tolkien, there is a mighty dragon named Smaug — one of the last dragons of Middle Earth.

Smaug, hundreds of years old, sits on a vast pile of golden treasure in the bowels of the Lonely Mountain. For all intents and purposes he is invincible — except for one flaw.

A single weak spot on the dragon’s underbelly leaves him vulnerable, and Bilbo Baggins reports on it. The next time Smaug ventures out, he is killed by an archer’s arrow aimed at this one improbable place.

If you’ll forgive the analogy, China, too, is a great old dragon sitting atop a vast hoard of wealth.

And, like the mythical Smaug, the real dragon (China) has one potentially fatal weak spot — the protectionist threat.

Those who champion China’s rise dismiss housing bubble and NPL (non-performing loan) fears as hot air. But they cannot be so sanguine when it comes to export risk.

In short, China may theoretically be able to weather a real estate bust and an implosion of bank balance sheets, thanks to heavy government involvement and plenty of cash on hand. But a dagger to the heart of the export model would be another story… and this is where the dragon is truly exposed.

Michael Pettis, a noted China watcher and finance professor at Peking University, sounded the alarm this week in the pages of the Financial Times:

The world seems to be marching inexorably towards trade war. The US trade deficit is surging, for reasons that have nothing to do with domestic consumption and everything to do with policies and events abroad. In the months ahead, the US will be forced to choose either protection or soaring trade deficits with rising unemployment. It will almost certainly choose the former but if it overreacts, which is likely, it could unleash another round of global protectionism – which will especially hurt trade-surplus countries.

- FT, The last chance to avoid a global trade war

China is especially vulnerable to protectionist backlash due to the instabilities of an exceptionally aggressive export model. Here is the gist:

• The mandate from Beijing is “employment over profit.”
• For China’s leaders, providing jobs is a social stability imperative.
• Exports have been, and continue to be, the engine of China growth.
• To maintain this growth, profit margins have been sharply reduced.
• In many cases, margins are so razor thin as to be almost nothing.
• This leaves China no room to adjust its foreign exchange policies.
• America’s demands for adjustment thus become impossible.

The alarming precariousness of China’s export model has been confirmed by various sources, most recently this analysis and commentary excerpt from Stratfor:

One of the things when we look at these Asian economies, these economies that are based very heavily on exports still, is that it’s very easy to have very high growth rates and yet not have a very strong profit margin. And that’s one of the issues that we have to look at when we look at the Chinese. Are they really creating wealth at home, or are they just creating a lot of flow-through in their economy?

For the government it’s imperative that they continue to find new jobs, new employment, that they continue to find the money for social services, for this very massive population. And, to do so, the Chinese have relied upon low cost exports, trying to become “the” exporter to the world.

To do that and remain competitive, you have to maintain very low margins, and one of the things we hear a lot from the Chinese companies is complaints that about just how low their margins are becoming, sometimes even to the point of being negative if it wasn’t for government subsidies.

The government and the economists in China recognize that they really need to shift to a more domestic oriented economy… that they need to increase domestic consumption… but the problem is they seem unable to do that. Every time they take steps to do that, it creates potential social backlash…

- Stratfor, China’s GDP and Questions of Strength

At the same time margins are being compressed by the “employment over profit” model, rising wage demands from Chinese workers are squeezing exporters even more.

The WSJ highlighted this trend in a recent piece, Rising Wages Rattle China’s Small Manufacturers:

The effects of China’s rising wages and stronger currency are rippling through the close-knit group of textile and garment makers in the eastern town of Zhili, and challenging the future of small-business success stories like it around the nation.

…the impact could be even more pronounced on China’s more than 10 million small businesses, which account for 60% of the economy and 80% of jobs…

…“If the currency appreciates 5% or 10% then we wouldn’t be able to do this business anymore,” as it would wipe out China’s cost advantage, says Cindy Wu, sales manager of Da Wei Zipper Co. Such fears from businesses are a big reason China’s government, despite outside pressure, is generally expected to limit the pace of its currency appreciation.

So, to recap,

• China is still deeply dependent on exports for growth.
• Rapid growth is an imperative for maintaining social order.
• Export margins, already razor thin, are further hit by wage pressures.
• Even a modest rise in the currency could destroy many businesses.
• If America challenges, China may have no workable response.

This is a macroeconomic train wreck in the making, especially when one considers the growing frustration in Washington over the perception of China’s unfair currency manipulation and mercantilist export policies.

From the UK Telegraph, US and China to clash over yuan fall:

China is on a collision course with Washington after steering its currency sharply lower to protect its export industries, despite a near record trade surplus of $29bn (£19bn) in July.

…Sander Levin, chair of the House Ways and Means Committee, said the US may have to consider retaliatory sanctions. “We must ensure that the international trading system ensures fair rules of competition. There is no real question that China’s deliberately undervalued exchange rate is unfair, contributes to global trade imbalances, and costs the US jobs,” he said.

Many on Capitol Hill suspect that China fiddled trade data with a “one-off” deficit in March when the Obama administration was preparing its verdict on whether Beijing is a currency manipulator.

The fact that China is willing to defy the wrath of Congress may indicate the degree of concern in Beijing over the sudden slowdown in the Chinese economy as credit curbs bring the property boom to a shuddering halt. Industrial output has slowed abruptly…

How will the above referenced “collision course” be avoided? It isn’t at all clear how we sidestep this.

And as Michael Pettis has noted, “trade war” risk sharply increases in times of stagnation and slowdown, with trade surplus countries in particular facing the backlash of “beggar thy neighbor” type policies. Plus along with the forementioned drivers, we can add the pressing need of U.S. politicians to “do something” ahead of key elections as another source of risk.

The implications of a full-on protectionism outbreak would be potentially devastating — not just for China, but the global economy at large. (Smoot Hawley, anyone?)

Nonetheless, the hopeful assumption that “cooler heads will prevail” given the high stakes has to be taken as just that, a hopeful assumption. Political decisions made at the populist level rarely take deeper considerations into account.

In terms of broad market impact, we know that investors hate uncertainty. The possibility of meaningful protectionist backlash, and a domino effect crisis in China as a result, is thus one more thing to consider vis a vis the risk-reward profile of being long equities.

In the medium term, we ultimately agree with Stratfor that China’s thus far inability to wean itself off a mercantilist-tinged export model spells serious trouble for the dragon, with reasonable odds of crisis — both economic and social — occurring sooner rather than later.

Finally, if you want to keep an eye on the latest out of China — and there is certainly plenty to watch there — the Mercenary Weekender routinely aggregates and sorts the weekly China news flow (along with many other key themes of the day).