Fire and Ice in China's Explosive Housing Market

China's real estate market is on fire. Housing prices in Beijing and Shenzhen are up about 140% in the last five years. Residential housing investment as a share of China's GDP has tripled from 2% in 2000 to 6% in 2011. Why is that a key figure? Because at the height of our housing bubble, U.S. residential housing accounting for ... that's right, 6% of GDP.

In the short term, a fiery housing market is giving off a cozy glow for China's rapidly emerging middle class. But China's leaders, having read one or several newspapers in the last few years, know that real estate conflagrations have a tendency to destroy your economy. That's why we're seeing market-cooling measures trickling out of Beijing, the Economist reports:

These included [property taxes in large cities and] higher downpayments for buyers of second homes. Owners of two or more homes were banned from buying more. The party also plans a big increase in the construction of government-subsidised housing.

Rising food prices offer a second, but related, challenge for the Chinese government. A cheap currency makes China's exports attractive, but also it makes the middle class' buying power artificially weak. As a result, China's middle class could feel the pinch of higher commodity prices even stronger than most countries, without heavy government subsidies or price controls. With a stronger RMB, the Chinese would be able to buy more food for fewer pieces of paper. But a stronger RMB, and the higher interest rates that might accompany it, would throw more water at the housing market.

How will this play out? I won't make predictions, but McKinsey Quarterly has a guess: poorly.

Middle-class bankruptcies will expand dramatically. Buyers have aggressively bought multiple properties with every penny of free cash flow. All that is needed for a wave of bankruptcies is further interest rate rises (targeting inflation) that result in a blip down in house prices just as mortgage payments rise. We have seen this before across major cities in Asia. The government will probably decide that it cannot bail such people out, as that would be seen as rewarding recklessness among the haves at the expense of the have-nots.