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China's real estate bubble is one more thing to fear

China's real estate bubble is one more thing to fear

It seems like two legs of the stool supporting the

global economy have already been kicked out: sovereign debt fears are plaguing Europe, while the United States emains mired in economic trouble.

What if the third leg were to bend or break?

That's the question investors are asking about China. The country has done a lot to support global growth over the last few years, with a surging demand for goods, services and commodities that has helped to mitigate the weaker performance in Western economies.

But China now looks increasingly at risk of a hard landing as it deals with a realestate bubble of its own and tries to bring inflation under control.

Real-estate speculation is a big part of the problem as developers have poured excessive money into new subdivisions catering to China's rich.

Typical of the excess is Thames Town, a satellite community outside Shanghai that was built as a faux British town complete with Victorian buildings, cobblestoned streets, red telephone booths and even a fish-andchips shop.

It's become the poster child for China's overbuilding problem. Despite intense marketing efforts, Thames Town never took off.

The quaint streets with names like High and Oxford are now deserted, the fishand-chip shop is closed and the whole place is a ghost town used only as a backdrop for wedding photos.

Speculative activity in real estate has been driven by the fact China's wealthy have few other ways in which to invest their money. But China's building boom has stretched much too far.

Across the country, "there is anecdotal evidence of vast unsold inventory resulting from large-scale development projects," notes respected Montreal investment analyst Tony Boeckh in his latest newsletter.

Following the global recession and financial crisis of 2008, China launched one of the world's biggest stimulus programs, resulting in a surge in construction.

Left to clean up the mess are local governments and lending institutions.

Trying to sort out the liabilities is not easy given the murky accounting rules and dodgy disclosure practised in China.

"A critical concern is the level of debt taken on by local government in the past few years," Boeckh says. China's municipalities are technically barred from borrowing money but get around the restrictions with off-balance sheet financing and special-purpose financing programs.

According to one official audit, local governments owe at least $1.6 trillion, or 27 per cent of national GDP for real estate projects, many with suspect economics.

"This constitutes a shocking addition to the national debt level and the actual figures could be much higher," Boeckh adds.

The huge increase in credit poses the risk of a financial crisis.

But Boeckh believes some factors are working in China's favour, making it unlikely the country will go down the same road as Japan did with its boom-and-bust real estate cycle.

China's level of private credit is much lower than Japan's was during its bubble and real-estate activity is being financed mainly by savings rather than borrowing.

Household debt stands at 35 per cent of disposable income, compared to 130 per cent in Japan in 1990.

Another factor to look at is demographics. Japan was a much older society when its bubble burst, whereas China is still seeing strong growth in its labour force and the share of its population in urban areas remains below 50 per cent.

Japan, as a modernized economy, had little room to grow its way out of its crisis but China has enormous potential for future growth in infrastructure, technology and household consumption.

Indeed, last week China reported second quarter growth of 9.1 per cent, up from 8.7 per cent in the first quarter. Authorities have raised interest rates five times since last year and could do so again to keep growth in check.

The question is whether they'll step on the brakes too hard. The betting so far is that gradual tightening will slow the economy down in the second half of the year and avoid a hard landing.