China’s securities regulator is putting pressure on top executives at local fund management firms and securities brokerages not to travel abroad until after the Olympic Games. This is a highly unusual request, especially when one considers that a big chunk of China’s growth has been fueled by international trade that depends on the mobility of top business leaders.

"Some in the industry suggested on Wednesday that regulators were also concerned about senior securities industry executives absconding with ill-gotten gains while the nation’s attention was diverted to the show in Beijing," wrote the Financial Times’ Jamil Anderlini on July 9. "In recent weeks China’s capital markets have been awash with rumors of an impending purge of industry and regulatory officials suspected of rampant insider trading and other illegal and irregular activities."

Civil unrest is also a big problem in China and it seems the government has figured out that "the threat of terrorism" is a useful tool to combat the unruly masses. For months, Chinese authorities have been publicizing the threat from separatist militants in the northwest region of Xinjiang, saying members of its Muslim, Uighur minority were bent on disrupting the Beijing Olympics. Is China using the "threat of terrorism" as an excuse to terrorize its own citizens? "China’s leaders are acutely aware of the risks of social unrest and they will be willing and able to try to spend their way out of trouble," reads a recent article in The Economist.

Nevertheless, terrorism remains a real threat in the near-term. China has said terrorism is the greatest threat to the Aug. 8-24 Olympics and that it has broken up several cells in Xinjiang, the oil-rich Central Asian region that borders Pakistan and Afghanistan. Officials in March also said they stopped a plan by a Uighur woman to bring down a flight from Xinjiang. On Tuesday, Chinese Foreign Ministry spokesman Liu Jianchao repeated reports in official media that there was no link between the Olympics and the bus bombings in Yunnan’s capital Kunming last week that killed at least two and injured 14.

Even if there are no disruptions at the Olympics, the outlook for growth is skewed to the downside once the Olympic flame goes out. The U.S. might escape a recession over the next few months, but there is a possibility that the rest of the world will eventually drag the U.S. into recession at the start of 2009.

"The irony in the current market is that it’s going to be the rest of the world that drags the U.S. into recession," wrote Matthew Johnson at ICAP Australia in a recent market note. "Europe is the swing man in the global growth debate – and if Europe really does turn over, I suspect that we will have seen the highs for commodity prices (to whom, then, will China export?)."

Hot money will continue to threaten the China fairy tale. "In 2006 China shocked the world by adding $247 billion to what was already the largest hoard of foreign currency reserves," wrote Michael Pettis and Logan Wright at the FT. "In 2007, if correctly counted, China took in more than twice that amount. So far this year it is on track to double yet again." They add: "It is increasingly clear that this level of reserve accumulation is not sustainable."

"But while vast and growing reserves have been an issue for China for several years, in the past few months something new and highly destabilizing has been added to the process," they continue. "The source of reserve accumulation has become much more volatile and perhaps intensely procyclical (exaggerating the swings of the economic cycle)."

So what is powering China’s accelerating reserve accumulation? "Probably hot money," says Pettis and Logan. "As it becomes increasingly clear that China must revalue its currency sharply or else face surging inflation and the threat of financial instability, more and more investors, business people and ordinary households are bringing money into China to take advantage of profits associated with the expected appreciation or to protect themselves from the losses they will incur with the rising renminbi."

Hot money is notoriously unstable and even more notoriously procyclical. When the economy is growing, or even overheating, inflows are likely to increase net investment and add even more fuel to the economic engine. But when conditions change and the economy begins to slow or the country faces financial risks, hot money is likely to flee the country, exacerbating the very conditions it is fleeing. China could be in for a rough ride.

"The increasing procyclicality of Chinese capital inflows could place the gradualist, consensus-driven Chinese leadership significantly behind the curve when the inflows reverse, when the government should be providing liquidity to the real economy rather than mopping it up," concludes Pettis and Logan. It seems possible that these flows might reverse when investors realize that the Chinese may have used the Olympic hype to cover up fundamental problems…

Disclaimer: I own FXP, UltraShort FTSE/Xinhua China 25 ProShares