Trouble with the bubble

Is the Chinese economic bubble about to burst? Indeed, is what we are seeing in China even a bubble? These hotly debated issues notched up a tick last week when it was revealed that Chinese manufacturing growth had fallen to its lowest level in two years.

In fact expansion was so minimal that it was only slightly above the level where a contraction would have been indicated.

But even the biggest Chinese economic doom mongers are not suggesting one piece of data tells the whole story. The official line in Beijing is that all is well and the 12th five-year-plan, which began at the start of the year, is on course and, despite a slowdown in economic growth, there is no need for alarmist talk about bubbles bursting.

This expression of blithe confidence is somewhat undermined by the strenuous efforts by the Chinese government to contain what appear to be bubbles. In the past nine months, interest rates have been raised five times, while reserve requirements for banks (which prevent the expansion of lending) have been raised nine times.

Meanwhile, in the extremely sensitive property market, the government has raised minimum down payments for second homes and is experimenting with higher taxes on these investments. Premier Wen Jiabao recently stressed his confidence in these counter-inflationary measures, emphasising that they will not detract from the policy of economic expansion.

Herein lies the rub, because the government seems to be pointing two ways at once. It wants to keep growth on a fast track, and it wants to take out inflation and prick asset bubbles. Moreover, what fuels economic growth in China is investment, not consumption. Personal consumption is seriously under-contributing to gross domestic product growth, a red flag for the doomsayers.

So the slack has been taken up by investment, much of it government directed and the bulk of it in property. Last year, sales of residential property accounted for an astonishing one-third of total retail sales. And the government has become increasingly reliant on revenues from property-related business to balance its books. This source of revenue last year accounted for a third of the total tax income.

Bubbles typically surface in property markets, which are also the lead indicators of economies in distress. Jim Chandos, president of the Kynikos Associates hedge fund, who predicted the collapse of both Enron and the US housing market, is now a major China bear.

Four months ago he told CNBC that, 'the property crash in China will be worse than it was in America or the UK'. He pointed out that construction accounts for 70 per cent of Chinese GDP. Other data suggests that most of this construction is speculative. The extent of this speculation is hard to gauge because official information is sparse and inaccurate. But one telling indicator comes from last year's report by China's national electricity authority that shows that some 65.4 million homes in 660 cities recorded no power usage.

This suggests a vast hinterland of empty properties built when loans for property were flowing, interest rates were low and there was a common belief that property could only go up. Construction starts rose by almost 41 per cent between 2009 and 2010. Property prices have doubled in the past decade, all of this following a pattern that mirrors how Japan's property bubble burst.

The government is also determined to restrain forces aligned for a yuan appreciation. This makes the currency an attractive target. As money flows into the yuan - including quite sizeable amounts from Hong Kong - money supply expands and so does inflation.

Then there is the much less discussed issue of Chinese government debt, which gets lost in all the talk about how Chinese money is saving the US government from default. Last month China's most senior auditor, Liu Jiayi, reported that local government debt had now reached US$1.7 trillion, equivalent to 27 per cent of GDP. Other estimates are higher.

The property market gives every sign of being about to implode, inflation is rising, growth is slowing and debt levels are on the rise - a classic recipe for a financial crisis.