The China bubble is a story that doesn’t look like it’s going away. China’s status as Australia’s most critical trading partner (and the major reason that Australia was able to survive the global financial crisis with minimal negative effects) is particular grounds for concern. And while Jim Chanos’ views that the Chinese economy is on a “treadmill to hell” have not yet eventuated, rampant inflation and short-sighted government policy does not bode well for the economic future of the world’s factory floor.

While the US and European (and in this column, Australian) housing bubbles have been well publicised, many appear to forget the China has an asset bubble of its own. China maintains a US-dollar peg, which means that its money supply has been expanding to keep up with Ben Bernanke’s debasement of the US dollar. China’s money supply has also been massively inflated by rampant bank lending. Bloomberg reported recently that China’s supply of money has risen by 48% in the past two years.

An increase in money supply is the classic definition of inflation. Rising costs (like a higher consumer price index), are merely symptoms of that inflation. These symptoms are starting to be felt, with Bloomberg noting that Chinese “food prices climbed 10.3% last month from a year earlier”, with “fruit prices [surging] 35% and grain [rising by] 15%”.

The flood of money in China has also had the predictable effect of surging asset prices and misallocation of resources. When the national inflation rate is high, it doesn’t appear to make sense for investors to place their money in relatively lower interest-bearing savings accounts (which in real terms, provide negative for investors). Rather, investors place their money in speculative assets such as shares or investment property. This feeds into a faux positive feedback loop, as the short-term return on assets increase, leading to more investors buying those assets in the hope of quick profits themselves.

This is one of the reasons for China’s construction boom. A boom that has been especially beneficial to Australian suppliers, which have been able to sell products such as iron ore and coal to a desperate Chinese marketplace. The problem is though, the demand for Australian  products isn’t real. Instead, it’s future demand that has been brought forward as a result of false price signals.

Gillem Tulloch, a Hong Kong-based analyst who has been investigating China’s property sector told SBS’ Dateline that China is in the midst of “a property bubble, like which I don’t think we have never seen [that] will make the United States pale into comparison”. Tulloch noted that “there is around 64 million empty apartments in China … it is the modern equivalent of building pyramids, it doesn’t add to the betterment of people’s life, but what it does is promote GDP growth”.

The problem, according to Tulloch, is that in China, it’s not really the market that decides where scarce resources are allocated, but rather, the government. “Because China is a command economy, and the Chinese government can basically dictate where resources are spent … essentially, they’re just building stuff for which there’s no demand, and ultimately that means they’re creating a large problem in the future”. China’s “ghost towns” were also noted in graphic fashion by the Daily Mail, which produced these graphic images of China’s housing bubble. The Daily Mail speculated that in some areas, Chinese property prices were overvalued by as much as 70%.

Any bubble has a story, a rationale for what otherwise would appear completely irrational behavior. In China, it is the myth of rapid urbanisation. That tens of millions of poor rural Chinese workers will move to the cities and suddenly become middle-class consumers. However, the excuse of China’s rapid urbanisation also appears somewhat suspicious. As John Lee noted in Business Spectator today, “we often hear the mind-boggling figure that around 15 million rural Chinese are moving to cities every year [however] the urbanisation rate is only slightly above 1% each year. Yet, Chinese consumption of iron ore has increased by 80% since 2003”.

It is not without irony that Australia’s housing bubble has been partially spurred by low unemployment and interest rates. These conditions have been helped by China’s bubble, which has created demand for Australian exports. We are quite possibly witnessing a Matryoshka doll bubble-within-a-bubble. If both bubbles pop, things will get ugly.