Be Very Afraid of The China Bubble

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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.