What happens if China's 'bubble' pops?

hu_china_bubble.gi.top.jpgChinese President Hu Jintao By Katie Benner, writer

NEW YORK (Fortune) -- World-renowned short seller Jim Chanos -- the hedge fund manager who called the fall of Enron and the systemic problems cause by subprime mortgages --recently turned his gimlet eye on China. He saw a country whose rapid rise was hiding massive flaws: grossly inflated real estate prices, irresponsible construction lending, massive overbuilding, a banking system larded with bad loans, and unreliable government data. Fitch Ratings weighed in this week saying that China's banks face the greatest "bubble risk" of any Asian country.

If Chanos and his fellow Cassandras are right and there's a bubble waiting to burst, investors might be surprised: The results won't be anything like the ones we've seen in the U.S. and Europe. In fact, a China "pop" would be much quieter than in the West -- but possibly still have huge, surprising reverberations for the U.S. Here's why:

The Party rules

The main reason asset bubbles will deflate differently in China is because the Communist Party controls, well, everything. Free-market policies have not stopped the government from manipulating markets in ways that go well beyond what we would ever see in the West.

For example, officials can implement strict price controls that can effectively keep the population from feeling the ripple effects of a popped asset class, says Charles Freeman, who focuses on the political economy of China and U.S.-China relations for the Center for Strategic & International Studies. So if real estate values tumbled, the government could artificially prop up the prices of other things to keep the economy from buckling under the weight of deflation. And the government has strict capital controls in place that can keep money from leaving the mainland.

Freeman also points out that China controls a large chunk of the banking system, so it can force banks to extend credit whether or not those institutions want to make loans.

"The government can really push money into enterprises to keep them going even amid a crisis," says Peter Morici, a public policy professor at the University of Maryland. "You wouldn't see a credit shortage like the one we saw in the U.S."

As for the rash of bad loans that could be made amid a period of forced lending, China has an answer to that, too. The government pushes debt problems off into the future and is notoriously opaque when it comes to reporting problems. For these reasons, bad debts would surface in a slow and hopefully orderly manner, Fitch wrote in its recent report.

The Party moves fast

As we saw with the massive $585 billion stimulus plan that China enacted amid the global financial meltdown, the government can move quickly without worrying about opposition parties or congressional slowdowns. During a crisis, time plays a huge role in damage control.

When inflation looked bad at the end of 2007, for example, the government quickly implemented strict price controls. This time, it could impose taxes on short-term profits made in the real estate market and tweak as necessary to slow investment, says Marshall Meyer, a professor of management at the University of Pennsylvania's Wharton School.

But the Party could go too far

Bubbles in China are about much more than finance. Economic upheaval is a source of potential mass unrest, threatening the Communist Party. "If asset bubbles were to burst, the government would be blamed for the pop," says Freeman at CSIS. "Would the leadership crack down on unhappy, protesting citizens? Would it stifle economic and other freedoms that have been the basis of the country's economic miracle for the past 30 years?"

In fact, to keep things flowing, it might open the spigots on exports and try to grow its way back, doubling down on its main engine of growth -- exactly what it did during the global meltdown. And that's where the U.S. needs to worry. An even more export-focused China would mean ever less-expensive goods flowing into the biggest market in the world -- the U.S.

"Because prices are so heavily managed, China could easily flood the U.S. and the world with extremely cheap stuff," says Morici. If nearly everything America buys is made in China now, just wait. The trade imbalance would spiral further out of control; and manufacturers in other nations fighting China for market share would be at a greater disadvantage.

"Remember, when we talk about bubbles, the stakes are the future of the Communist Party," says Morici. "They'll try to survive no matter what; and it could mean destroying other economies to do it." To top of page