By Dan Denning
There are at least three scenarios we know of that could blow up this little moment of global financial tranquillity. There are probably more. But those are the unknown unknowns. In today's Daily Reckoning, we're going to focus on the known unknowns. They are the things we know could be bad. But how bad is what remains unknown.

Why this three part thought experiment? Well, just because our analysts are in agreement that the cautious way forward is to surf the liquidity in the markets higher, your editor is, at heart, a massive worry wart. Plus, all these disaster movies about the end of the world must be affecting our state of mind, or amplifying its natural tendencies.

We're always worried about the worst-case scenario, always thinking of the things that could go wrong. This just seems like a prudent way to prepare. It will be better if these things don't happen. But let's just assume they will and work backward from there. And then let's figure out what you can do - if anything - to avoid getting wiped out again, and maybe even making a buck or two on it.

First cab off the rank is the total implosion of the Chinese economy. This might be bearish for Aussie resource stocks. But how likely is it to happen?

Well, not very likely if all you were looking at is the raft of official data released this week. Retail sales in China were up 16.2%. Industrial output was up 16.1%. And exports, even though they were down 13.8% in October, decreased at the lowest rate in ten months. Fixed asset investment for the year is up 33.1% over last year's pace.

You could take all of these as signs that China is leading the world to recovery and managing itself quite well. It should achieve 8% GDP growth. That's the growth rate that China's economic planners reckon the country must achieve to maintain high unemployment. And high employment rates promote political stability - valued above all else by a regime that makes free market gestures but still is run by old school communists.

What's more, if you take up the question we asked a few weeks ago - when is it in China's interests to allow its currency to strengthen - the answer is starting to emerge: when a stronger currency keeps inflation in check. China's currency managers are making noise about letting the Yuan strengthen against the dollar.

But it's not to please Barack Obama, who visits Beijing this month. A stronger Yuan, among other things, gives Chinese consumers more purchasing power. That might slowly reduce the contribution exports make to Chinese GDP and to forex reserves which are then recycled into U.S. Treasuries.

Or it could all fall apart more quickly than anyone expected. Why?

China has massive over capacity in steel and cement. Granted, these two materials are quite literally the building blocks of industrial society. But according to Bill Powell in Fortune Magazine, China has enough spare production capacity in the cement industry to meet annual cement demand from India, Japan, and the U.S....combined!

This fact would be consistent with a country that's massively over-investing in fixed assets to achieve high rates of employment. And then there's steel. China's own National Development and Reform Commission says the country will have 250 million tonnes of excess steel production capacity by the end of next year.

Chinese steel production is approaching 600 million tonnes per year. But its current demand is around 350 million tonnes. That means it's either planning to put the rest of the world's steel makers out of business by dumping cheap steel on to global markets...or there is massive overcapacity and inefficiency in the steel sector.

Either way, it's probably a good idea to consider the possibility that China's investment binge is more fragile than it looks. In short, the bear case on China is that, "the Chinese have dangerously overheated their economy, building malls, luxury stores and infrastructure for which there is almost no demand, and that the entire system is teetering toward collapse."

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Naturally this would be bad for Australia, whose economy is lately coupled with China's prosperity. It would argue for reducing your allocation to common stocks, raising your cash position, and not taking the China growth story at face value.

Next cab off the rank is global rush to refinance debt while interest rates low. Moody's reports that there is $10 trillion of bank debt maturing between now and the end of 2015. What's more, the average maturity of bank debt fell from 7.2 years to 4.7 years over the last five years.

This means bank debt (like sovereign debt, especially in the U.S.) is getting more interest rate sensitive. Not only do banks have to roll over a lot of debt in the coming years, they may have to do so at higher rates (assuming they can find takers for it.) Moody's is not confident.

In a research note published to clients, and also on the FT's Alphaville blog, Moody's analysts wrote that, "credit costs should continue to put banks' earnings and profitability under considerable pressure, which might cause investors to seek additional risk premia, as governments gradually exit from the direct support they have so far provided. In other words, we see weaknesses on both sides of the balance sheet, and we are concerned that the risks associated with both assets and liabilities may fuel each other, cause losses and undermine investor confidence."

Even if you concede that Moody's might be overly-dire now to make up for its non-existent warnings about the risk of sub-prime related debt, you have to take the warning seriously. In fact, in a report released last weekend, the IMF said banks were not out of the woods yet at all and remained at risk.

Its analysts wrote that, "Banking systems remain undercapitalized, suffering from impaired legacy assets and, increasingly, non-performing loans. Deleveraging pressures will likely remain a constraint on bank credit for some time. Activity in securitization markets remains dependent on public sector support. Moreover, large public interventions have transferred risk to sovereign balance sheets, raising market concerns that have abated somewhat recently."

We'll get to the sovereign balance sheets in a second. But in your financial disaster preparations, spare a thought for the banks. Serious problems remain. And if you're looking for where risk resides in the financial system today - the next AIG, or Mrs. O'Leary's cow if you prefer - you might not have to look any further than the banks.

But as the IMF noted, a great deal of private sector risk has been transferred to the public sector via bailouts, loan guarantees, and other schemes. This exposes sovereign borrowers like the U.S. and the UK to interest rate shocks (increased borrowing and debt service costs). But more importantly, these countries already faced fiscal dilemmas with ageing populations.

There is not much detail to add to this point. We've covered it before. But it's the best reason to own gold and tangible assets (your house, vodka, cigarettes). All the world's paper currencies are drowning under a sea of public sector debt that's becoming increasingly unsustainable. And this has happened at just the point where the Western welfare states will begin spending more money on caring for ageing populations.

Where will the money come from? Between a China meltdown, a bank implosion, and the rising risk of sovereign debt default, there are at least three known unknowns that worry us right now. And don't even get us started on the unknown unknowns.  (Courtesy: Daily Reckoning, Australia)