For the past year, the People’s Bank of China has been caught between two contradictory policy paths of equal priority. It has either had to raise rates to slow inflation, or lower them to spur the domestic economy. If either failed, it could spur social unrest. Complicating this balancing act was a third, and equally threatening risk: a real estate bubble, which has the potential to hurt both the economy and the financial system.

Until its surprise move to cut reserve requirements for banks by 50 basis points last week, the PBOC has been tackling both the inflation and property market risks with a bias toward gradual policy tightening, implicitly suggesting that it’s prepared to let growth slow a bit to contain those risks.

But now, with Europe almost certainly entering recession and the global growth outlook deteriorating, the downside economic risks are showing up. And that has serious implications for the world economy and for currency allocations.

On Dec. 1, HSBC’s China PMI fell to an unexpected 28-month low of 47.7 in November from 51 in October, perpetuating a downtrend in place since November last year and pushing the indicator into the sub-50 contraction territory. And on Thursday China announced that industrial output growth dropped in November to its slowest pace in two years: 12.4% from 13.2% the month prior.

To be sure, inflation also fell sharply, with consumer prices showing just a 4.2% on-year gain in November, compared with 5.5% in October. But although that gives the PBOC breathing room to take more easing measures–most likely through more reserve requirement reductions–it might also suggest that the slowdown is greater than the market expected.

And the most important factor in that risk is in the still-unresolved problem of the real estate bubble. Although foreigners have been accustomed to thinking of exports as the engine of Chinese growth, some 70% of it has come from internal real estate investment, according to Kynikos Associates’ Jim Chanos–admittedly, one of the most prominent China bears.

A popping of that bubble will have devastating consequences for the global economy.

Although various Chinese cities have reported a precipitous decline in home purchases in recent months, prices are virtually flat. That suggests a possible disconnect in monetary policy and the risk of big declines to come, posing a serious risk to the banks that financed the bubble and to the construction industry that has kept China booming.

After all, raising rates to slow a housing boom is one thing; lowering them without a coincident fall in prices while an economy slows is not likely to have the same effect.

If China were to stumble, so should its currency, the yuan. But if it depreciates, it could inflame political tensions in the US. so throw geopolitical risks into the problems Beijing has to deal with.

With all the plates in the air that China is spinning, most analysts still see its leaders managing a “soft landing.” They may be heartened by the latest inflation numbers, but I am not so sure.

These are not long-term capitalists with great experience managing a free market economy of 1.3 billion people.

The circus in Europe has been a diversion from the real problem. The inexperience of China’s leaders to manage an economy being pulled in two different directions is the real threat to global growth.

So what does this mean for FX? For one, it means the Aussie dollar is possibly the most overvalued currency. Its proximity to China have made it China’s favorite source for raw materials. The biggest reason for gains to Australia and her currency.