The China Bubble is About to Burst

Special Report

The China Bubble is About to Burst

China has the world's largest population and second largest economy.
In the last few years, it's seen an outstanding economic growth rate, averaging 9 to 10%.
The fact that China is now the worlds largest trading country makes this pretty significant.
But in the second half of 2012, this fell short... Growth was 7.6%, a three-year low.
Another red flag appeared towards the end of the summer when the Purchasing Managers' Index, which measures manufacturing activity, fell to a nine-month low — dropping from 53.1 to 52.0. The 50-point mark separates expansion from contraction, and though China's number was still above that line, it was hovering dangerously close.
One thing after another has had analysts turning a suspicious eye to China, a quickly-developing nation that, until now, had inspiring economic growth. And one after another, these analysts are all asking the same question: Is China's economy on the brink of decline?
Analysts suspect economic growth this year will fall between 7.5% and 8.0%, but policy issues could push this down even lower — maybe even to 7.0%.
The rapid economic growth has built up bubble after bubble, climbing a steep slope to the peak...
Now it looks like there's nowhere to go but down.
Corruption at the Top
Government corruption has been the link behind all of the slowing sectors in China. High-ranking officials and their self-interest have perpetuated the economic bubbles and pushed many sectors to the current point of instability. And it's these officials that will continue to push them past the point of no return.
One of the biggest scandals that lit up the news recently was that of former Chinese politician Bo Xilai's wife, Gu Kailai, who was tried and convicted for the murder of British businessman Neil Heywood. The murder took place after an alleged dispute between Heywood and Gu Kailai, during which Heywood was said to have threatened the woman's son.
But this trial, which repeatedly made international headlines, is just the tip of the iceberg for Chinese government corruption...
Other instances are much less public, lack hard evidence, and are therefore all the more treacherous to the economy.
In March the son of senior party official Ling Jihua was killed in a car accident. It wasn't the tragic death that struck suspicion, but the circumstances surrounding the event: Ling Jihua's son was driving a Ferrari when he crashed, a car worth $270,000.
His father, meanwhile, makes a reported annual salary of $15,000. The car was worth 18x his father's annual pay. 
Many have become suspicious that Ling Jihua was taking bribes in order to afford such a luxurious vehicle. It seems like the only logical way he could own a car worth eighteen times his annual income.
And while officials like Ling are taking extravagant bribes, the surrounding economy is starting to rot away...
Strong Production, Weak Demand
The steel sector may be one of the most deeply affected.
The price of imported iron ore has dropped by almost half over the past year hitting a three year low in September. Iron ore is a key ingredient in steel, and this dramatic price drop is indicative of weakened industrial demand. Because of this, steel prices are down as well...
But steel manufacturers haven't slowed their trade.
The steel-making business in China is, for the most part, state-run. This means that the local governments benefit from tax revenues.
And even though Chinese steel businesses have not been profitable lately — demand and prices are both down, but manufacturing is up — the businesses are bringing in revenue. It's the taxes from this revenue that matter to the local governments. 
Meanwhile, the steel traders are put in a tight spot.
One trader from the Henan province discussed the business with the Financial Times: “We have to try every possible means to sell [our steel] even if we lose money. We will lose more if we don't sell.”
But they're not selling. They're just isn't demand to support the over-manufacturing from the industry.
Government officials, however, are focused on bringing in local government revenue... and steel manufacturers and traders are being buried under the weight of overproduction.
Housing Bubble
Another factor weighing on China's growth (perhaps more than we even know) is the housing bubble.
With such a massive population, China has plenty of bustling, overcrowded cities: Shanghai with over 16 million people; Beijing with a population exceeding 12 million; and Chongqing with more than 9 million residents, among others.
But just as distinct are the empty buildings in these areas.
Last  year it was revealed that in Beijing alone, there were 3.812 million vacant homes.
That's over one million more vacancies than in the entire United States at that time.
Jim Chanos, president of Kynikos Associates, has been warning about a Chinese housing bubble for several months. It's these vacancies, he believes, that will contribute to the burst: “In China's GDP calculations, they don't look at final sales, they look at production. So a condo being built but not sold contributes to GDP.”
And vacant businesses count here, too...
In China's Dongguant, for example, the New South China Mall has 9.6 million square feet of floor space, its own indoor roller coaster, and less than twelve shops.
All over China, massive building projects like these intended to boost GDP remain empty.
As Chanos told CNNMoney: “This is a country that's in the middle of an epic property bubble that will end at some point and it won't be pleasant when it ends.”
Amid all this empty space, housing prices remain unreasonably high.
The central government in Beijing is trying to impose restrictions to prevent price increase for housing, but local governments just aren't having it. In fact, prices have been going up since the start of this year:

The local governments tend to have relationships with housing developers. Often the banks are involved. These groups benefit when prices are high.
Beijing is trying to put a stop to this, but it's having a tough time doing so.
Bad Loans
But that's not the only kind of manipulation in which the banks are involved...
While other nations like Greece and Spain have recently taken the cake for bad credit, China is not much better off.
One of the biggest issues plaguing the credit sector is the large number of “bad loans.”
A report by the rating company Standard & Poor's showed just how bad the situation is. Ryan Tsang, a Hong Kong-based analyst, wrote in the report: “A credit turndown is unfolding in China. Massive market-driven consolidation may be in the cards for many players as credit quality becomes dramatically polarized.”
In August the 3,800 banks across the nation reported a rise in the number of non-performing loans. It marked the third quarter of this increase.
Desperate to stay afloat, businesses are looking for extensions on existing loans, and though the banks are reluctant to comply, local politicians are pressuring them to do so.
The situation continues to get worse. Corporate delinquencies continue to increase, net interest margins get smaller, and liquidity management is “increasingly strained.” And S&P expects this to continue for the next three to five years.
Chanos is bearish on China's credit sector. As he said during an interview with Opalesque TV:

The interesting thing about the China story getting back to the macro and micro, and as dire as I think the macro story is — due to bad credit and credit extension that makes Greece and Spain and the U.S. look like child's play — when you get to the micro of individual companies, they look even worse...
The accounting is horrible, they all seem to have negative cash-flow, noncollectable receivables, they all seem to not earn their cost of capital.

Precarious Balance
China's growth target for 2013 is 7.5%. If it fails to meet this, GDP will be at a twenty-year low. The nation's exports are declining quickly, heading back to 2008 levels. And the threat of inflation lingers...
China imports much of its corn and soybean, but the U.S. drought this summer hurt the crops, pushing up prices.
China's will maintain a 4% inflation target this year, and a good harvest from the U.S. this year was expected to help keep it down. But now that the harvest is expected to be weak and prices are rising, inflation could hit China once again.
If China hopes to stabilize this precarious balance, it will require a lot more cooperation from the local governments. The central government will need to ramp up regulations, and it will need to work closely with each one of these weakened sectors.
Li Zuojun, deputy director at the Development Research Center of the State Council, wrote in a paper detailing the specific ways China must overcome its economic challenges:

If the government uses a superb macro-control technique, lets the air out of the bubbles little by little without triggering an economic crisis or social unrest, and timely cultivates new economic growth and new competitive advantages so that businesses are restructured and upgraded...the bubbles would not burst. However, in 2013 there will be unprecedented pressure, which will warrant a high degree of vigilance and attention.

But if government corruption continues to overshadow this “vigilance and attention” to economic growth, China's situation will get worse... to the point that thirty years of growth will implode.