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08/03/2010

The imminent bubble is already affecting the rest of the world. The strong demand in China's voracious construction industry has also led to sharp rises in the prices of commodities like aluminum, iron and copper. Not surprisingly, a recent survey showed that more than two-thirds of all Chinese hope that the real estate bubble will burst soon. Many sense that China's brand of government-controlled capitalism is still a long way from being a market economy capable of self-regulation.

The political leadership reacted in April when it sought to curb speculative fever by instructing banks to approve fewer mortgage loans. At the same time, the required minimum down payment for the purchase of second homes was increased to 50 percent. The government is also thinking of taxing home ownership in the future.

But these measures are risky. In addition to curbing speculation, they could also stall the rest of the economy. The real estate sector is responsible for 20 percent of fixed investments, which could lead to an unwanted effect: If China starts building fewer apartment buildings and houses, sectors like the steel, glass and cement industries could end up with substantial excess capacity.

Crash or Soft Landing?

Notorious pessimists aren't the only ones painting these scenarios. Even Prime Minister Wen Jiabao recently admitted: "China, with its macroeconomic measures, faces an unexpectedly large dilemma." The fundamental risks are already reflected on the Shanghai Stock Exchange, where real estate and bank assets account for a quarter of market capitalization. The stock index fell by 27 percent in the first half of this year.

But is a real estate crash truly inevitable, or will China's economic planners manage to bring about a soft landing? Cao Jianhai of the Chinese Academy of Social Sciences in Beijing likens the Chinese economy to "a volcano before an eruption." Nevertheless, he doesn't believe that the government of Hu Jintao, the Communist Party leader and president, and Prime Minister Wen will allow a crash to occur before its term in office ends in 2012 -- local governments are too dependent on the real estate boom. According to Cao, Beijing will go to "any expense" to pump money into the financial system and spur a renewed surge of rapid economic growth.

But the bubble could burst in two years, says Cao, and then it will be up to Hu's and Wen's successors to correct the situation. In the worst case, Cao predicts, there could be a large-scale run on the banks. "Of the 4 trillion yuan in the Chinese economic stimulus package, 3 trillion are in fact coming from local governments -- and they borrowed the money from the banks."

Another Lost Decade?

There is an interesting historical parallel to the new Chinese bubble. With its excesses, such as luxury villas, amusement parks and golf courses, China's real estate bubble bears a striking similarity to the Japanese bubble of the 1980s. At the time, the property occupied by the emperor's palace in Tokyo was supposedly worth as much -- on paper -- as the entire state of California.

Admittedly, there are many differences between the aging island nation of Japan and the giant market that is China. In the People's Republic, more than 10 million people migrate from rural areas to major cities each year, an influx that does in fact create additional demand for apartments. But the current boom does not address this real demand, says Cao. "Migrant workers are poor and cannot afford the apartments, which are usually much too expensive."

After its bubble burst, Japan suffered the so-called "lost decade," which was followed by a second decade of crisis. Cao is convinced that China, too, will pay a heavy price for its dependence on the real estate boom: "Our industrial development will be delayed by 10 years as a result."

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• Part 1: China's Real Estate Bubble Threatens to Burst
• Part 2: Bubble Drives Up Commodity Prices