Special Report: The China Bubble is About to Burst

China has the world's largest population and second largest economy.

The fact that China is now the world's largest trading country makes this pretty significant.

But in 2015, this fell short... real GDP growth was 6.9%. Just 2 years ago GDP growth was at 7.7.

China GDP Annual Growth Rate

Another red flag appeared towards the end of the summer. The Purchasing Managers' Index, an indicator of health in the manufacturing sector, fell to 50.1. Anything below 50 implies recession.

The 50-point mark separates expansion from contraction, and though China's number was still above that line, it’s hovering dangerously close.

One thing after another has had analysts turning a suspicious eye to China, a quickly-developing nation that, until now, had inspiring economic growth. And one after another, these analysts are all asking the same question: Is China's economy on the brink of decline?

The rapid economic growth has built up bubble after bubble, climbing a steep slope to the peak...

Now it looks like there's nowhere to go but down.

Strong Production, Weak Demand

While China's exports have been severely weakened by global recession, then stagnation, Chinese industry has yet to adapt.

As a result, there is a severe overcapacity problem across many industries, especially steel, cement, glass, shipbuilding, wind power, and solar energy.

Cement manufacturers use only 71.9% of their capacity, the steel industry clocked in at 72%, and the glass industry at 73.1%.

Central government figures have been trying for years to shutter inefficient manufacturing capacity and shift to higher-value products, but local officials will not stop undermining their efforts.

This has been going on for a decade with steel production. Steel mills often pretend to shutter unnecessary production, only to restart it later. Others secretly add new capacity as local officials look the other way and take a cut of the action.

A deputy director of the Cabinet planning agency said, "Those who still violate discipline will be heavily punished."

Some local officials even follow the orders to tear down old and inefficient steel mills, only to replace them with bigger mills.

With the revenue this creates in their area, the bribes they often collect from owners, and a political system that judges them on their role in economic development, nothing will substantially change in the foreseeable future.

Housing Bubble

Another factor weighing on China's growth is the housing bubble.

With such a massive population, China has plenty of bustling, overcrowded cities: Shanghai with over 24 million people; Beijing with a population exceeding 21 million; and Chongqing with more than 9 million residents, among others.

But just as distinct are the empty buildings in these areas.

Reuters reports that there are 13 million vacant homes in China.

Jim Chanos, president of Kynikos Associates, has been warning about a Chinese housing bubble for quite some time. It's these vacancies, he believes, that will contribute to the burst: "In China's GDP calculations, they don't look at final sales, they look at production. So a condo being built but not sold contributes to GDP."

And vacant businesses count here, too...

In China's Dongguant, for example, the New South China Mall has 9.6 million square feet of floor space, its own indoor roller coaster, 26 shops, and a 99% vacancy rate.

All over China, massive building projects like these intended to boost GDP remain empty.

As Chanos told CNNMoney: "This is a country that's in the middle of an epic property bubble that will end at some point and it won't be pleasant when it ends."

Amid all this empty space, housing prices remain unreasonably high. Prices so high that it’s nearly impossible to get residents into these homes.

The housing market was once a significant contributing factor to China’s booming economy, but now it’s become a huge drag on China’s falling economy.

Frank Chen, executive director of China research at real estate company CBRE says:

Real estate is the single most important sector of the Chinese economy...Local governments in particular rely on property. So the government is always worried about its impact on growth.

According to Moody’s Analytics, The construction, sale, and outfitting of homes contributed to 22% of China’s GDP in 2013, 19.8% in 2014, and 15.1% in 2015.

Mark Zandi, chief economist of Moody’s Analytics says, “Housing will not be a durable source of growth for the Chinese economy, at least not for the foreseeable future.”

Local governments continue to restrain price growth by enforcing stricter lending regulations and restricting nonresidents from buying homes, but that's easier said than done.

Bad Loans

But that's not the only kind of manipulation in which the banks are involved...

While other nations like Greece and Spain have recently taken the cake for bad credit, China is not much better off.

One of the biggest issues plaguing the credit sector is the large number of "bad loans."

A report by the rating company Standard & Poor's showed just how bad the situation is. Ryan Tsang, a Hong Kong-based analyst, wrote in the report: "A credit turn down is unfolding in China. Massive market-driven consolidation may be in the cards for many players as credit quality becomes dramatically polarized."

In the previous fiscal quarter, nonperforming loans were up 3.2% to $217 billion.

Desperate to stay afloat, businesses are looking for extensions on existing loans, and though the banks are reluctant to comply, local politicians are pressuring them to do so.

The situation continues to get worse. Corporate delinquencies continue to increase, net interest margins get smaller, and liquidity management is "increasingly strained." And S&P expects this to continue for the next three to five years.

Chanos is bearish on China's credit sector. As he said during an interview with Opalesque TV:

The interesting thing about the China story getting back to the macro and micro, and as dire as I think the macro story is — due to bad credit and credit extension that makes Greece and Spain and the U.S. look like child's play — when you get to the micro of individual companies, they look even worse...

The accounting is horrible, they all seem to have negative cash-flow, noncollectable receivables, and they all seem to not earn their cost of capital.

China’s credit binge runs a huge risk of a banking crisis for China’s economy. The gap between credit and GDP hit 30.1 in the first quarter of this fiscal year. The Bank for International Settlements (BIS) says, “any level above 10 suggests that a crisis will occur 'in any of the three years ahead.'"

Precarious Balance

China lowered their growth target for this year to 6.5%-7%. China has been finding it more and more difficult to meet their growth targets in the past few years.

The nation's exports are declining quickly, heading back to 2008 levels. And the threat of inflation lingers...

In June, exports fell 4.4%, while imports declined 12.5%. Not to mention China's top export market, the U.S., fell at an astounding 10.4%.

Julian Evans-Pritchard, an economist at Capital Economics said this about the slowdown of China’s imports and exports:

The country’s export growth is likely to remain subdued for some time. While we think the worst is probably over for many emerging markets, global growth is likely to remain lackluster well into next year.

If China hopes to stabilize this precarious balance, it will require a lot more cooperation from the local governments. The central government will need to ramp up regulations, and it will need to work closely with weakened sectors.

Li Zuojun, deputy director at the Development Research Center of the State Council, wrote in a paper detailing the specific ways China must overcome its economic challenges:

If the government uses a superb macro-control technique, lets the air out of the bubbles little by little without triggering an economic crisis or social unrest, and timely cultivates new economic growth and new competitive advantages so that businesses are restructured and upgraded...the bubbles would not burst.

Government tools like easy credit, increasing exports, and infrastructure spending are no longer effective solutions to revive growth in the economy.

China’s situation is getting worse… to the point that thirty years of growth will soon implode.

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