• World

Be Very Afraid of The China Bubble

11 minute read
Ken Miller

What’s the most important economic question in the world today? One contender is whether the euro will collapse. Another is whether the U.S. will plunge into a double-dip recession. But a third, and possibly the most important over the long term, is whether China can save the world–or whether the entire country is a $6 trillion bubble that’s ready to pop.

That’s the size of the Chinese economy, now the second largest in the world, after the U.S.’s. China contributed 19% of global economic growth in 2010, and that’s expected to increase to 24% this year. China’s strength is essential to the recoveries of both the U.S. and Europe; if Beijing crashes, the reverberations will be felt from Boise to Brussels.

And plenty of smart people are worried that it will. It may seem strange to Americans who hear so much about the rise of Asia and the pressure of Chinese competitiveness, but there are big questions about China’s future. For more than 30 years, the Chinese miracle has been built on cheap labor, cheap land and cheap capital. But the model is starting to break down. China’s banks, which have doled out too many bad loans, are perhaps as troubled as those in the West. The frothiness of the real estate market in major Chinese cities makes the U.S. housing peaks of 2007 look positively staid. Inflation is growing, as are unemployment–particularly among the middle classes, for whom, as in the U.S., there aren’t enough high-level jobs–and social unrest. China’s own Premier, Wen Jiabao, calls his nation’s economy “unbalanced, uncoordinated and unsustainable.”

Nowhere are the problems more evident than in the real estate sector, which has been at the core of the country’s growth and development. Like Republicans in the U.S. who try to “starve the beast” by cutting government spending, the Chinese Communist Party has been attempting to put a damper on the nation’s debt-fueled real estate boom. This is part of a deliberate attempt to rejigger the economy into one that relies more on domestic consumer spending and less on manufacturing and exports. To ensure its future growth, China must move from being the world’s factory to being one of its largest consumers. If, however, the party’s efforts to take the country in that direction result in a precipitous drop in real estate values, the entire economy could crash. Multinational corporations whose revenue and earnings growth are tied to China could be hit hard. And the U.S. could be thrown back into recession.

While very few economists doubt that China’s growth is going to slow eventually, it’s a question of how much and how soon. Will the landing be hard or soft? So far, the signs are mixed. GDP growth has moderated slowly in the past few quarters rather than falling off a cliff (though it’s worth noting that Chinese economic figures, as released by the government, are a notorious black box). Yet in many parts of the economy, the bubble continues to expand. Local-government debt grew about 30% in 2010 from the previous year. In the first six months of this year, Chinese investment in real estate was up 33% from the same period in 2010.

In order to understand the potential fallout from a China bubble, it’s important to understand how the bubble began. The popular narrative is that China’s rise from nowhere in 1978 to its position today has been fueled mainly by an inexpensive and massive labor force. That’s part of it, but equally important have been low-cost capital and land. Most Chinese, who are huge savers, have little choice but to put their money in bank accounts that pay interest rates lower than inflation; in a country with a relatively undeveloped financial sector, there are few other options. These funds are then channeled into state-owned enterprises whose capital expenditures create the factories and skyscrapers on which the Chinese miracle has been built.

But the Chinese are pretty smart about money. They see the fortunes the elites have made by buying land at bargain prices and developing it. Ordinary individuals cannot get in on the ground floor to reap the obscene profits made by well-connected officials who broker–often by force–these purchases from the properties’ historical owners, but they are permitted to invest in real estate at later stages of development. And so housing is where much of the wealth in the Middle Kingdom ends up. Anyone who’s spent more than a day or two in China knows that real estate is a popular preoccupation. Apartment flipping is all the rage; real estate prices have tripled in the past five years.

The question is whether the bubble–not only in housing but in commercial property as well–is about to pop. Everywhere you go in China, you see new airports and high-speed-train lines under construction; glass-fronted apartment buildings whose empty units loom unilluminated in the night; underutilized roads, bridges and tunnels; and entire towns waiting for occupants. One such town, Kangbashi in Inner Mongolia, has everything a city needs, including investors who have bought apartments on spec. Yet it remains largely vacant.

Why does China keep building? Because building creates jobs and wealth for those who are associated with all that development. Right after Mao Zedong came to power in 1949, the party dedicated the country to a massive social-industrial complex under direct control of the government. Many of the early government-controlled institutions were dismantled in the post-1978 Deng Xiaoping era, and the focus for the past 30 years has been on production and exports fueled by state capital expenditure–something the party could control. Eventually, those investments created factories that churned out made-in-China goods, an infrastructure that supported the factories and a building boom that has culminated in a glut of high-rises all over the country.

The problem today is that this model, which has worked so well for over three decades, is showing signs of fatigue. Chinese factories are aging, and their counterparts across Asia are now poised to compete. Returns on investment have been declining. At the same time, wages are slowly rising, which is one reason manufacturing jobs are trickling back to the U.S., as the labor costs between the two countries narrow.

The growth-at-all-costs model followed for the past three decades has exacted enormous costs on Chinese society. Yet despite undrinkable water and unbreathable air in many parts of the country, the party continues to enjoy widespread support; its p.r. machine emphasizes its efforts to redress China’s humiliation at the hands of the West in the 19th and 20th centuries. Even intellectuals who gripe about personal-freedom and civil rights issues seem to do so through a filter of sincere patriotism. Unfortunately, the strains caused by hell-bent growth are starting to show up everywhere. Mass protests of party abuses–often the taking of land without just compensation–have been multiplying so steadily that the government, departing from past protocol, did not publish the number of them last year. At government facilities in many regions of the country, there have been explosions set off by citizens so disaffected that they didn’t care about the consequences.

Beijing knows it’s time to change strategy. The party’s latest five-year plan shows that it wants to shift away from the old export-and-building-boom model to one that relies more on domestic demand for goods and services. But as China is finding out, this is easier said than done.

If the party’s attempt to rein in the easy money flowing to state-owned enterprises results in a dramatic decline in property values, the outcome could be an earthquake in the Chinese financial system that would be felt in the U.S. In the past, loans made by state banks to big government-related businesses created a significant amount of bad debt that had to be written off. In 1998 and 2004–05, loans totaling about $500 billion were classified as nonperforming, and state officials transferred them to special investment vehicles in an attempt to create the appearance of containing the problem. But because the state, which owns the biggest banks–and thus the people’s savings–ultimately pays the price of any write-off, households bear the cost of the cleanup. Chinese banks are the original too-big-to-fail financial institutions.

There are rumors across the country that another big round of write-offs is imminent. The amount might be equal to or greater than the sum of the two previous write-offs. If Beijing is serious about moving its economy to a consumption model, imposing the cost of these bad loans on citizens again will be a serious impediment to its goal. Household income as a percentage of GDP has been declining in China for almost a decade, and it’s hard to see what the people are going to use to buy stuff, even if wages rise, if they have to keep paying for bailouts and can’t earn anything on their savings. It is one thing for the government to lower taxes on consumer goods, as it recently did, but unless it can reverse the decline in household income as a percentage of GDP, the people won’t spend.

Another problem Beijing has in moving to a new growth model is local and provincial governments’ addiction to revenue from land sales. According to the Ministry of Finance, land sales totaled $500 billion in 2010, more than double the amount in the previous year. Because provincial officials are promoted on the basis of their GDP-growth figures and because land sales are an important part of local revenue, it’s difficult to curb the enthusiasm of local officials for project development.

Of course, nothing is ever a bubble until it bursts. Even an empty city is not a convincing warning to those who remember that it took Shanghai many years to build its now booming Pudong business district. Although some of those pristine new bridges, roads, tunnels and buildings may be underused today, they might prove to be just the catalyst needed to keep the economy driving forward when demand catches up, as the optimists vehemently argue.

But if the bubble pops, it will have serious consequences in America. The U.S. sold $92 billion in goods and services to China last year. If China succeeds in moving away from its model of cheap land and cheap capital and makes a smooth transition to an economy based more on domestic demand, hallelujah. But if Chinese land prices plummet, there will be less demand for raw materials and a steep decline in world commodity markets and global trade in general.

That could very easily lead to even higher unemployment in the West. The U.S. economy is already in the strange position of having cash-rich companies that are not spending or hiring. Imagine how much less inclined they will be to spend and hire if they are frightened by a Chinese economic slowdown, especially given that so many of them have pinned their future growth prospects on China. And the U.S. government, already shedding jobs in the aftermath of the 2008 crisis, will be in no position to ride to the rescue.

Whatever GDP figures might suggest, senior Chinese officials, a number of whom I speak with regularly, are quite worried about a hard landing. Many observers say a sharp economic decline won’t be permitted to happen before the next change of party leadership, in 2012. But the Chinese stock market was not supposed to be allowed to crash in the run-up to the 2008 Beijing Olympics, and it did.

As the Chinese Communist Party tries to engineer this delicate shift in the nation’s economic model, the U.S. could do a lot to help. It could, for example, avoid starting contentious squabbles over things like trade and currency at a time when populist political sentiments in both countries are high. Rather than bash China, it could focus on encouraging the export of services and goods to the Middle Kingdom. (U.S. exports there have already grown 468% over the past decade.) It could also remember that China’s transformation from a poor developing country into a richer one with a larger middle class has been tricky–both economically and politically. China is, as Deng would have put it, “crossing the river by feeling for stones.” It’s a process in which some scrapes are inevitable. The key will be avoiding a fall.

Miller is managing partner of Keylink Capital International and a member of the State Department’s advisory committee on international economic policy

More Must-Reads from TIME

Contact us at letters@time.com