How a Chinese Real Estate Bust Could Hurt the U.S.

China and the U.S. are locked in a sort of economic mutually assured destruction, in which we need them to lend us money and they need us to buy their low-priced products. So if China's economy gets into trouble, the U.S. will feel the effects. That's why reports of a possible real estate bubble in China matter to people in the U.S. The evidence supporting the China bubble case is compelling, but the challenge is to figure out when the bubble will pop and how China will react.Before looking at these questions, consider the evidence suggesting a Chinese real estate bubble. The New York Times reports that super-star short seller James Chanos -- who bet right on the collapse of Enron -- has now set his sites on China's real estate market. Chanos views China as "Dubai times 1,000 - or worse" and suspects that Beijing is faking its reports of 8% GDP growth, according to the New York Times.

But Chanos did not supply the Times with much more evidence on which be based his December 2009 short position. For more evidence of China's real estate bubble, let's turn to DailyFinance's Charles Hugh Smith who provides statistics suggesting that China has built way more real estate than its citizens can afford to purchase -- and it has done so at a growth rate that makes the worst of the U.S. housing bubble look like child's play.

How so? Smith points out that housing starts in China spiked 194% in 2009 -- and 90% of the new supply is targeted towards the luxury market. Unfortunately, the typical 1,000 square foot apartment in Beijing sells for 80 times the average income of that city's residents. This leads to huge amounts of excess inventory being held as investment property generating no cash flow.

What Happens Next

Exactly when this bubble might burst is hard to say. My own experience is that it can take at least two years from the time people start talking about a bubble bursting and the actual pop. I told BusinessWeek in 2002 that I thought the U.S. was heading towards a real estate bubble, but the bursting of the bubble didn't being until 2006 with the collapse of some sub-prime lenders.

Let's say that China's real estate bubble does burst in the next year or two, what could happen to China's economy? Of course, the people who invested in that property could be wiped out, especially if they borrowed money to purchase it and could not sell the property at a price exceeding the loan principal amount. And China's banks would then take big write-offs of the unpaid real estate loans.

On the other hand, China's real estate industry differs in at least one crucial respect from that of the U.S. As The Atlantic reminds us, the U.S. financial crisis was a result of the securitization of mortgages -- but China does not follow that practice. Therefore, the impact of a bursting Chinese real estate bubble would likely be muted, limiting the worst effects to real estate developers.

Nevertheless, if people who borrowed money could not pay it back, China might need to scramble to raise cash to keep its banks above water. In that case, it might sell a chunk of its $2.2 trillion in U.S. debt -- which would likely drive up interest rates in the U.S.

How so? Such selling would massively increase the supply of U.S. debt on the market at the same time that China's demand for it would be evaporating. With a $12 trillion national debt, such higher interest rates could lead the U.S. into another round of economic contraction as a greater portion of our GDP goes to paying higher interest payments on the debt.

How much this might cost and how bad the ensuing contraction might be is hard to quantify. But whatever the details, there seems little doubt that the bursting of a Chinese real estate bubble could have a nasty effect on the U.S. economy.

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