What If the China Bubble Bursts?

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Michael Christopher Brown / Corbis

Ghost town Empty streets in Kangbashi, Inner Mongolia

What's the most important economic question in the world today? One contender would certainly be whether the euro will collapse. Another might be 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 find its way out of the biggest housing bubble ever created.

It may seem strange to Westerners, who hear so much about the rise of Asia and growing Chinese competitiveness. But like U.S. Republicans who try to "starve the beast" by cutting government spending, the Chinese Communist Party has been attempting to put a damper on the debt-fueled real estate boom that is at the heart of the nation's economic miracle. This is part of a deliberate attempt that is meant to rejigger the Chinese economy into one that relies more on a domestic service sector and less on manufacturing and exports. If, however, the party's efforts result in a precipitous drop in real estate values, multinational corporations whose revenue and earnings growth are tied to China could be hard hit. And the U.S. could be thrown back into recession.

The world has to care about Chinese growth, since it is an important driver of the global economy. China contributed 19% of the world's economic growth in 2010, and that's expected to increase to 24% this year. China's growing strength is essential to both the U.S. and European recoveries.

While Washington has sweated through its partisan debates on budget balancing and economists have bickered over solutions to our low-growth and high-unemployment problems, the Chinese boom of the past several decades has blasted ahead without a glitch. Much of that boom is wrapped up in real estate. In the first six months of this year, Chinese investment in real estate was up 32.9% compared with the same period in 2010, and China's economy is expected to grow more than 9% this year, about equal to its average during the post — Deng Xiaoping era of "communism with Chinese characteristics."

The popular narrative is that China's rise from nowhere in 1978 to its position today as the world's second largest economy has been fueled by cheap labor. While this is one factor, cheap capital and land have been as important. Most Chinese, who are huge savers, have little choice but to put their money in bank accounts that pay interest lower than the rate of inflation; these funds are then channeled into state-owned enterprises whose capital expenditures create the factories and buildings 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 facilitate purchases from historical occupants, but they are permitted to invest in real estate at later stages of development, and their wealth grows every year. 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 building bubble — not only in housing but in commercial property as well — is about to burst. Everywhere you go in China, you see new airports and high-speed train lines under construction; see-through apartment buildings whose empty units loom unilluminated in the night; beautiful underutilized roads, bridges and tunnels; and newly risen ghost 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 unoccupied, as reported last year in this magazine. Why does China keep building? Because building creates jobs and wealth for those who are associated with all that development.

Right after Mao came to power in 1949, China experimented briefly with driving growth through internal consumption, but this led to a flight of capital and dependence on foreign borrowing that scared the leadership. The party decided to focus on production and exports fueled by state capital expenditure. The factories that churned out made-in-China goods and the infrastructure that supported the factories encouraged the building boom that has culminated in a glut of high-rises all over the Middle Kingdom.

The problem today is that this model, which has worked so well for over three decades, is showing signs of fatigue. Factories that make things the world wants were built long ago (and factories in many other parts of Asia can now churn out goods more cheaply than China). Returns on investment have been declining.

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 rising so steadily that the government 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 don't care about the consequences.

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