How will China handle its real estate bubble?

China’s economy has been on a rocky path since the global financial crisis of 2008. Many observers have decried the existence of massive excesses in property investment, warning the country’s economy is too reliant on a property bubble that is waiting to burst. Yet China marches ahead. In April, The Financial Times estimated that, for the first time since the 1870s, this year China will be the world’s largest economy, supplanting the United States.

There is massive overinvestment in property across China. For example, one observer recently told me that apartment builders in Beijing do not even bother finishing the buildings because they sell the properties to investors, not consumers who are looking for a home. The existence of vast, uninhabited ghost towns and vacant shopping malls springing up across the country has been widely documented.

However, in order to truly understand the state of China’s economy, we must first appreciate the fact that it is not a typical capitalist country. To a large extent, the state directs investments even of privately held firms. For example, private banks in China are closely linked to the state in ways not seen elsewhere. While Western central banks backstop private banks when they engage in bad lending, China takes an active role in telling financial institutions where and to whom they should extend credit.

In response to the 2008 financial crisis, China ramped up lending by undertaking much of the economic stimulus through private banks. This stimulus now accounts for a large share of bad loans in the Chinese banking system and the excess in investment in property. But lending has since slowed down enormously from its 2009 peak. The following graph illustrates the growth in money supply (M2) in China over the last decade and half.

The key problem here is that China’s economy is far too reliant on investment. The country runs a trade surplus and a government budget deficit. The governments thus spends more than it is taxes, and the rest of the world buys more goods from China than it sells in China. For this reason, the surplus income flowing into the Chinese economy can end up only in two places: Chinese workers’ savings accounts or the profits of Chinese firms and capitalists. Economists call this phenomenon the Levy-Kalecki profit equation. Under this principle, if workers are not well paid and spend most of their income on consumption rather than saving it, then most of the investment spending will accrue as profits to either firms or capitalists.

This tendency is reflected in the fact that China’s widening income inequality has surpassed that of the U.S. This is because when profits are high and workers’ savings are low, most of the wealth generated accumulates with the upper classes. Because of the structure of income distribution in China, a massive stock of wealth has been created at the top end of China’s economy. This probably accounts for anecdotes such as builders turning over half-completed apartments blocks to investors. These investors have too much cash on hand and will buy up large properties even if they don’t generate immediate returns on investment.

Thus the wide disparities of income and the fact that China is developing at an extremely rapid rate are two sides of the same coin. Because of the relatively low worker saving and consumption rates, capital — in the form of housing, buildings and factories — can accumulate at whirlwind speed. But this gives rise to a troubling dynamic similar to a spinning top: In order to keep the economy moving, investment spending has to continue to generate sufficient demand for goods and services. If the rate of investment starts to slow, the top could quickly grow unstable and wobble.

In the meantime, since goods in China are relatively cheap, workers can still be kept content. Factories produce massive amounts of inexpensive products for export to foreign markets. Any surplus is then dumped in local markets at cutthroat prices. This ensures that the extremely low nominal income of the Chinese worker can go a very long way.

Even if the government and private banks continue building cities and malls with no end user in mind, a potential property bubble will likely provoke reform. This would have to come either as income redistribution in the form of higher wages or as the Chinese government’s socializing idle buildings being generated by the property bubble for the public benefit in the form of public housing and civic buildings. This might require some added investment on the part of the Chinese government, but this is far preferable to leaving them idle.

China’s political system is extremely complex and opaque. When such a reform would come is anyone’s guess. From the outside, it appears that there are two distinct factions in the Chinese Communist Party: the neoliberals and the socialists. The neoliberals want to maintain the status quo, while the socialistic bloc, which often uses slogans and songs from the Maoist era to promote their ideals, seem intent on pursuing wealth redistribution.

Ultimately, the future of China’s economy hinges primarily on political issues. Despite a popular belief among business writers, China is not a normal capitalist economy. It is much closer to the state-directed economies that the West built in the aftermath of World War II than it is to today’s free-market economies. For this reason, if China is to turn a corner anytime soon, the change will come from within the Communist Party, not the financial sector.