As the U.S. economy inches toward something that may resemble a recovery, a situation is playing out in China that, given the billions of dollars per year in commerce that is conducted between Los Angeles and China, could only have a direct impact on the economic health of Southern California.

Within the next 18 months, the Chinese real estate market will overheat, explode like a supernova and result in untold political and economic “reforms.”

How do I know this will happen? Because it hasn’t happened before. No one in China has any idea how an overheated market can quickly devolve into a pyramidlike scheme, how a pyramid scheme devolves into an overheated market – and what that even looks like. For those of us who do, there are three clues to the coming apocalypse: overbuilding, overspeculation and blind obedience to easy money.

Overbuilding

Without equal, for the last 15 years, the No. 1 wealth creator in China has been real estate. With massive subsidies from local governments and Chinese government banks throwing money at projects like rice at a wedding, builders have been on a construction spree the likes of which I have never encountered. Last year, a study conducted by my organization, the North Central China Real Estate Association, discovered what has been termed the Five Percent Rule. This rule suggests that there is an undisclosed regulatory policy to promote the construction of enough housing units each year to equal approximately 5 percent of the current or projected population. This amounts to tens of millions of new units in 2011 alone. Yet, 2011 is not an aberration but a continuation of the curve of the last 10 to 15 years.

Overspeculation

As China is and shall be for the foreseeable future a source of low-wage manufacturing, there is no practical way of absorbing such a massive, growing and expensive inventory. Only a fraction of the population can actually afford their own unit. Most of the high levels of absorption took place 10 to 15 years ago.

But during the last five to eight years, that curve has reversed itself. Virtually all units sit empty, with the only activity coming from workers performing constant maintenance and repair on these monolithic echo chambers. The only thing keeping units moving are speculators. The units are sold but no one lives in them. I have visited at least 50 massive apartment plazas with a minimum size of 10,000 units throughout China. I observe the empty streets, the deserted common areas, and ask the developers and their agents how many units are sold. Almost without exception they proudly reply, “All of them.” 

Blind obedience to easy money

Even the guys who are not in the real estate business want to get into the business and have zero interest in any other industry or investments … other than building more units. Making money in real estate seems just too easy.

There is also another driver here. There is no developer “legacy” in China. No one on the mainland has done this longer than 15 years at the most. As recent as 1994, other than the 10-lane Chang’An Boulevard, Beijing was still a series of dirt roads lined with single-story shanties. Basically, modern Beijing only began construction in earnest during the last 10 years, with the bulk of it in the last four to coincide with the 2008 Beijing Olympics. “Professional developer” is a new industry here. With that knowledge, the government brought in Hong Kong companies with seasoned professionals who could develop a reasonably decent quality product. 

But that has now shifted. The problem is that for that last five years the mainland group has become far and away the largest group building in China, but it lacks the fundamental characteristics for successful long-term development: experience and foresight. Projects are now being done by rookies. And these guys are getting in for one reason: easy money.

I am sensitive to the notion of self-fulfilling economic prophecies and the effect of naysayers on good times – the economic party-poopers, if you will. I understand that if enough people express enough pessimism, eventually the marketplace follows. With that knowledge, I have watched patiently as things have unfolded. But the evidence seems pretty clear. Rampant overbuilding (which should depress prices) has given way to skyrocketing prices throughout the country due only to pyramid schemelike speculators, and the entire process shows no sign of slowing because of the seemingly easy money to be had and the Five Percent Rule. But the mix is economically toxic. It’s impossible to discern the result of an event that has never happened before. But is safe to assume that when the pyramid collapses, it will be pretty ugly.

The fact is when a major trading partner of Los Angeles goes boom, Los Angeles will be saying ouch.

Jeff LoCastro is founder and president of the North Central China Real Estate Association, chief executive of California Secured Investments LLC, an expat living in China and a
serial entrepreneur.