What If the China Bubble Bursts?

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Michael Christopher Brown / Corbis

Ghost town Empty streets in Kangbashi, Inner Mongolia

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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 it is finding out, this is easier said than done.

One problem the authorities have run into is their inability to stop cheap capital from flowing into state-owned enterprises. These businesses use the money they borrow to invest directly in real estate or lend to others who do so. The business elites owe their management positions to the party, and they continue to arrange access to cheap capital, which allows them to grow their profits while improving their standing in the hierarchy. 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, a total of about $500 billion was classified as nonperforming loans (which state officials transferred into 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 the write-off, households bear the cost of the cleanup.

There are rumors around the country that another big round of write-offs is imminent. If Beijing is serious about moving to a consumption model, imposing the cost of these bad loans on citizens again will be a serious impediment to that 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 of 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 grow into the now booming Pudong. Although some of these beautiful, ubiquitous new bridges, roads, tunnels and buildings may be underused today, maybe they will prove to be just the catalyst needed to keep the economy driving forward when demand catches up, as the optimists argue.

But if the bubble pops, it will have serious consequences in the U.S. America 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 do so if they are frightened by a Chinese economic slowdown. 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.

Senior Chinese officials are secretly quite worried about a hard landing. Many observers say a sharp economic decline won't be permitted to happen before the change of 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. The Chinese Communist Party is trying to engineer a delicate redefinition of how its economic model will work going forward. The last thing it needs right now is U.S. sanctions against Chinese imports. A more constructive approach, one that recognizes that the U.S. and China are in the same global economic boat together, would be for the U.S. to incentivize the export of technologies aimed at helping China grow its service sector. The U.S. needs an economically stable and growing China to buy not just its IOUs but also its goods and services.

Miller is managing partner of Keylink Capital International, a strategic financial adviser on international transactions

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