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5 Reasons China's Bubble Might Be Ready to Burst

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The past decade has been kind to China, and investors have been privy to a country growing at breakneck speed. Year-over-year GDP growth has averaged 10.5% over the past 10 years, and in most instances it eclipsed the double-digit growth mark.

But what makes China so functional and able to weather worldwide downturns could also become its undoing.

Personal consumption black hole
It's no secret that China and its people have done an amazing job stimulating its economy by investing and attempting to drive the wealth machine, encouraging its citizens to save, save, save! From 1982 to 2007, China and its citizens jumped aboard the savings bandwagon as national savings as a percentage of gross domestic product jumped from approximately 34% to 54%. This period also witnessed one of the most precipitous drops in personal consumption ever witnessed. In 1982, personal consumption as a percentage of GDP stood at 52%; by 2007 this figure would drop to just 35%.

Under normal circumstances, in a healthy economy, we would expect the personal consumption to rise along with GDP, but we simply aren't seeing that with China. One reason could be that the wealth effect seen in China is simply artificial. Investment rather than consumption is what's driving growth, and this usually proves to be unsustainable in the long term. Real wealth appears to be tied up in the banking system and not with the general public. Personal consumption's disconnect with GDP is a major red flag that Chinese consumers may not be able to sustain this economy any longer.

History has a tendency to repeat
Running a consistent trade surplus does have its advantages. China recently became the world's largest creditor and now holds roughly 8% of all outstanding U.S. debt. The U.S. does bear an AAA credit rating at the moment, but let's be honest about this, China is still a novice when it comes to lending.

For all the smart moves China has made when it comes to investing, it has placed nearly all of its eggs in one basket -- a basket that, may I add, bears a AAA-rated country that's having a hard time controlling its spending. In addition, China has been actively purchasing Spanish debt despite fears that it may succumb to rising lending rates and sovereign debt worries.

As noted European bear and hedge-fund manager Hugh Hendry pointed out last year, there have only been two times in history where the largest creditor has also run large trade surpluses: the U.S. in the 1920s and Japan in the 1980s. Both countries unsurprisingly faltered shortly thereafter into their worst respective recessions/depressions in their history. Could China be next?

Commodity inflation could kill
Prices for steel, copper, silver, aluminum -- practically any commodity you can name -- remain near multi-year highs largely because of demand from China. These higher-priced commodities are fueling China's growth, but they also have the potential to cut off its lifeline.

Recent data showed that China's consumer price index rose to a 34-month high of 5.5%. The CPI is a loose measure of inflation within China and shows that rising food, energy, and commodity prices are likely beginning to take a toll on lower- and middle-income citizens. The Chinese government has responded by raising lending rates four times since the financial crisis hit the rest of the world, and it's hardly made a dent, as the CPI suggests. Since businesses have ample cash, the wealth machine can motor higher, while on the other hand, China's citizens get shut out of the credit market as rates continue to rise.

Housing bubble?
Let the United States housing market serve as an example that nothing can go up forever.

Many analysts have been waiting for the shoe to drop in the Chinese housing market for years, and it just hasn't happened yet. Housing prices across China have risen by 140% over the past eight years, with Beijing's housing market being the poster child for opulence -- up roughly 800%.

Fueling this surge in prices is a mixture of government-led grants and bank-financed deals. Commercial business vacancy rates remain low and present the clearest reason why building demand is moving higher.

Unfortunately, as has been the case with nearly every point here, the Chinese citizen is still relatively poor. In a country where the typical worker makes the equivalent of $2 U.S. a day, it's becoming increasingly difficult for an average Chinese citizen to buy a home. Government-imposed restrictions -- such as raising the lending rate and boosting the amount of cash needed for a down payment -- have in effect priced the majority of China's citizens out of its own market. While China's overall vacancy rate remains tame, I have to agree with Moody's downgrade of China's housing market in April from stable to negative, assuming a primary reason was the continued construction of new housing with so many vacant units still on the market.

Investors losing trust
This one goes without saying and without argument: Investors are losing faith in Chinese investments.

Chinese firms have been listing on U.S. stock exchanges in droves over the past few years in the hopes of cashing in on their IPO. Lately, investors have been ringing the register as quickly as they can to escape Chinese equities before they come under the harsh scrutiny of the Securities and Exchange Commission. Just this year alone, we've seen accounting scandals from Rino International and China MediaExpress, while countless others are halted pending review, including Puda Coal (AMEX: PUDA  ) and Longtop Financial Technologies (NYSE: LFT  ) . Even a company like Harbin Electric (Nasdaq: HRBN  ) isn't immune, falling earlier this week to $6 despite a prior buyout offer by the CEO for $24 per share!

Foolish forecast
There's no denying that China's growth rate has been torrid, but denying these warning signs could be the difference between a good night's sleep and your portfolio's demise. History backs up the thesis that China's run is bound to fail sooner rather than later, so invest wisely, my friends.

Would you put your money to work in China right now? Share your thoughts in the comments section below and be sure to check out our 13 Steps to Investing Foolishly to see if you're doing everything you can to protect your investments.

Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy that just wants the facts, ma'am.

Read/Post Comments (5) | Recommend This Article (8)

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  • Report this Comment On June 24, 2011, at 11:46 AM, MKArch wrote:

    Amen Sean nothing goes up forever. I've been in the Chanos camp on China for a couple of years. Your mention of vacancy rates being tame is surprising given some of the statistics Chanos has presented such as office construction on the books about a year and a half ago being the equivelent of a ~5 ft. x 5 ft. cubicle for every man woman and child in China. It seems as though a lot of the official statistics in China are suspect are you sure the vacancy rate statistics are accurate?

    I know some people are questioning just how accurate the official stat of construction representing 70% of China's GDP is but if it's remotely close to accurate it's going to be a huge problem when the finally stop building. Personally I'm avoiding any investment that relies on China and weighting to the U.S. where commodity prices coming back to earth with China will be a boon and we hardly sell anything to China. Just like personal consumption will turn into China's downfall, our trade imbalance will be our saviour.

  • Report this Comment On June 24, 2011, at 11:55 AM, jrsept1 wrote:

    Bubble ? The stocks have been down for about 6 months....about time to re bubble.

  • Report this Comment On June 26, 2011, at 9:54 AM, dkangan wrote:

    While I share the author's caution about Chinese stocks, this article gets a lot of what is going on in China wrong.

    The demographics of the housing boom are simply different from those in Western economies. The large eastern cities, along with Chengdu and Chongqing lead the way there. An inexhaustible stream of newly educated population is flows from the interior to these cities. It is for this reason that I was wrong in my predictions of a pop in the bubble in 1999: the demand is virtually endless. The government is cooling it off, though, with new regulations limiting the number of housing units one can buy. But the Chinese are past masters at scamming the system, so I see this as a temporary cooling action.

    Consumerism as a percentage of GDP is pretty meaningless in China. Even if you buy the governments figures for economic growth, the effect of that growth is limited to a pretty small slice of the population, mostly located in the aforementioned cities. where consumerism is booming in every segment. If we picked a number like 5%, we are still talking about a massive number of consumers.

    But what never makes the news is rising commodities prices. This tells us that the yuan is in fact much against world currencies than the markets think. So lots going on.

  • Report this Comment On June 26, 2011, at 10:56 PM, anuvaka wrote:

    I own 4 Chinese based stocks and all of them have had severe losses in the past 5-6 months. Some due to strategic shorting and 'hedge funds' created to deny proper accounting practices.

    The Government of China does not look at "gains" or "profits" as the US or Euro nations account for them.

    Until the Chinese government adheres to GAArP type accounting, full disclosure, and an international monetary policy I will not be investing in another China based stock. Global Gains be dammed, it really is not worth it.

    China has a narrow view of economies, looking for it's own gains and oblivious to the "World" situation. I agree there has been a lot of profits made in China, but not for the investor, not for the 'common' China-man.

    Until they have a World View, I'm outa-here. Yeah I will hold my current stocks to see if they can recover, but I don't expect to become a 'Fool me Twice' investor.


  • Report this Comment On June 27, 2011, at 7:06 AM, Bonsaiscrooge wrote:

    I would never invest a penny in a country ruled by a dictatorship, whether it declares itself communist, fascist or capitalist, even with the prospect of immense profit. I'd be ashamed of myself.

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