China's Bubble Problem

Is China really strong enough to bear the economic burden that the world is trying to put on its shoulders? US President Obama wants China to bail out his debt saturated government, but is that policy sustainable?

China's communist government owns a large part of the money-creation and money-spending apparatus. Money supply therefore shot up 28.5 percent in June. Since it controls the banks, it can force them to lend, which it has also done.

Finally, China can force government-owned corporate entities to borrow and spend, and spend quickly itself. This isn't some slow-moving, touchy-feely democracy. If the Chinese government decides to build a highway, it simply draws a straight line on the map. Any obstacle -- like a hospital, a school, or a Politburo member's house -- can become a casualty of the greater good. (Okay -- maybe not the Politburo member's house).

Although China can't control consumer spending, the consumer is a comparatively small part of its economy. Plus, currency control diminishes the consumer's buying power. All of this makes the United States' TARP plans look like child's play. If China wants to stimulate the economy, it does so -- and fast. That's why the country is producing such robust economic numbers.

Why is China doing this? It doesn't have the kind of social safety net one sees in the developed world, so it needs to keep its economy going at any cost. Millions of people have migrated to its cities, and now they're hungry and unemployed. People without food or work tend to riot. To keep that from happening, the government is more than willing to artificially stimulate the economy, in the hopes of buying time until the global system stabilizes. It's literally forcing banks to lend -- which will create a huge pile of horrible loans on top of the ones they've originated over the last decade.

But don't confuse fast growth with sustainable growth. Much of China's growth over the past decade has come from lending to the United States. The country suffers from real overcapacity. And now growth comes from borrowing -- and hundreds of billion-dollar decisions made on the fly don't inspire a lot of confidence. For example, a nearly completed, 13-story building in Shanghai collapsed in June due to the poor quality of its construction.

This growth will result in a huge pile of bad debt -- as forced lending is bad lending. The list of negative consequences is very long, but the bottom line is simple: There is no miracle in the Chinese miracle growth, and China will pay a price. The only question is when and how much.

...Now, China needs to stimulate its economy. It's facing a very delicate situation indeed: It needs the money internally to finance its continued growth. However, if it were to sell dollar-denominated treasuries, several bad things would happen. Its currency would skyrocket -- meaning the loss of its competitive low-cost-producer edge. Or, U.S. interest rates would go up dramatically -- not good for its biggest customer, and therefore not good for China.

This is why China is desperately trying to figure out how to withdraw its funds from the dollar without driving it down -- not an easy feat.

And the U.S. government isn't helping: It's printing money and issuing Treasurys at a fast clip, and needs somebody to keep buying them. If China reduces or halts its buying, the United States may be looking at high interest rates, with or without inflation. (The latter scenario is most worrying.)

All in all, this spells trouble -- a big, big Chinese bubble. Identifying such bubbles is a lot easier than timing their collapse. But as we've recently learned, you can defy the laws of financial gravity for only so long. Put simply, mean reversion is a bitch. And the longer excesses persist, the harder the financial gravity will bring China's economy back to Earth. _FPvia_ImpactLab