Baidu.com, Inc. (ADR) (BIDU): Why China’s Surging Economy Is in Trouble

Much has been made of China’s rapid economic growth in recent years. The world’s second-leading economy has grown from an average regional player 30 years ago into a powerhouse today, commanding a gross domestic product of more than $12 trillion when adjusted for purchasing power. According to the OECD, China’s GDP will overtake the U.S.’ for the top spot worldwide by 2016.

But is China really the economic superpower many have been hyping it as? A closer look reveals a country facing numerous challenges in the years ahead — and a nation that isn’t ready yet to take its place at the world’s economic peak. Investors caught up in this growth story shouldn’t overlook a Chinese future fraught with risks.

A rising middle class brings problems
The rise of China’s middle class is one of the pivotal demographic shifts of the early 21st century. The OECD currently estimates that about 10% of China’s population is in the middle class — a number that could grow to as high as 40% by 2020. With that rise comes a bevy of problems that threaten to derail the government’s lofty growth predictions.

China’s government has made no small show of its desire to urbanize its mostly rural population. While hundreds of millions of Chinese live in peasant conditions today, Beijing plans to bring many citizens into cities over the coming years. That move will be costly: Many middle-class citizens in China already vie for more benefits as the Chinese economy grows, and increasing welfare — particularly as the urban population swells — will crimp Beijing’s coffers and hurt plans to invest more into areas of critical need, such as infrastructure. Forget about leveraging its economic size internationally; China will have a hard time keeping up domestically.

Housing costs have exploded in Chinese cities as the nation’s urban population swells. Prices in Beijing grew more than 8% year over year in March alone, and the Chinese government’s attempts to curb housing prices have met resistance from municipal half-measures and reluctant local officials.

It’s doubtful that the housing market will crash like America’s did in 2007 and 2008 — JPMorgan’s chief exec of Chinese investment banking points out the strong demand and low leverage in the country’s housing sector — but there are other reasons for concern. The growing bubble in housing prices in a culture that prides home-ownership could push many younger people of the middle class to overpay for housing, which threatens budgets and consumer spending — perhaps the most important cog of leading economies around the world.