Be Very Afraid of The China Bubble

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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.