China's housing crisis is much worse than the one in the U.S., according to a Chinese government minister, and given the scale of its pumped-up real estate bubble, suddenly deflating it could have global consequences.

"The housing market problem in China is actually much, much more fundamental, much bigger than the housing market problem in the U.S. and UK before your financial crisis," Li Daokui, a member of China's Central bank monetary policy committee, told the Financial Times.

The worst consequence of a burst housing bubble might be a huge spike in interest rates. But fear of an even bigger force -- Chinese citizens' anger at the high cost of real estate -- could tame China's efforts to constrain the housing market.

111 Times Median Family Income

There is some data to support Li's concerns. For example, official Chinese data showed real estate prices in 70 cities climbed 12.8% in April, the fastest one-month annual rise in five years, according to AFP. During the height of the U.S. property bubble in 2005, house prices rose an average of 22% a year, only to plunge 20% in 2009, according to Standard and Poor's.

But even more striking is the gap between what Chinese earn and what they must pay to buy a residence. AFP reported that in 2009 a typical 970-square-foot apartment in Beijing cost $278,160 -- 111 times the average annual income of $2,514. By contrast, in November 2007, the average U.S. house sold for $316,800, a relatively modest 5.4 times the median household income of $58,480.

What Is to Be Done?

The key question for Chinese policymakers is what to do about the bubble. Li is among the inflation hawks at the Chinese central bank, but there are others with a more dovish attitude towards inflation. And on that score, China's official statistics reveal relatively modest inflation of 2.8% in April, compared to 0.9% in the U.S.

Li has been calling for increases in taxes and higher interest rates to keep the Chinese real estate bubble from bursting too suddenly. AFP reports that China currently has no residential real estate tax, but does charge 1.2% on 70% to 90% of the value of commercial real estate. China will try to impose a residential real estate tax to slow down the bubble, in addition to "tightening restrictions on advance sales of new property developments, introducing new curbs on loans for third-home purchases, and raising minimum down payments for second homes," according to AFP.

Not all Chinese economic policymakers are as hawkish. China Business News quotes Bank of China economist Cao Yuanzheng as saying China would keep rates unchanged until the U.S. Fed raises its rates to keep "hot money" from flowing into China. Cao clearly fears an outcome like that of Iceland, that attracted money from around the world to its 8% deposit rates. That money fled as Iceland's banks got into trouble.

What it Means for the U.S.

The good news for the rest of the world is that China's banks don't securitize residential mortgages and so aren't at risk. As I wrote in January 2010, a bust in Chinese real estate would hurt property developers instead of bankers and homeowners. If the Chinese government decided to help bail developers out, it might sell some of its $2.2 trillion in U.S. debt holdings, and those sales could raise U.S. interest rates -- depending on the appetite for that debt from other investors around the world.

But the bigger effect of a Chinese real estate bust would depend on the outcome of the debate between inflation hawks like Li and inflation doves, such as Cao. If China unilaterally decides to shut off the spigot of government capital to real estate, the resulting rise in interest rates would force the Fed into a difficult position.

That's because the Fed might then feel pressure to raise rates in order to attract investors to U.S. debt issues. Without such increases, the market might force an even higher rise in interest rates.

Fear of a Bigger Chinese Bubble: Social Unrest

But in all likelihood, China's primary concern will be keeping a lid on social unrest, which is likely to burst out of control if its people get too frustrated because they can't afford a place to live as they move from the country into the urban areas.

Raising taxes and interest rates in China are likely to create what Chinese leaders fear is an even scarier bubble -- one of popular anger.

And that fear should impede Li's more hawkish efforts to push China into letting the steam out of its real estate bubble.

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