Audio Transcript:

In the second part of our series on China's real estate bubble, The World's Mary Kay Magistad looks at why China's government wants to keep the bubble inflated.

MARCO WERMAN: I'm Marco Werman and this is The World, a co-production of the BBC World Service, PRI and WGBH Boston. There is a lot to be said about how the U.S. is in debt to China, to the tune of hundreds of billions of dollars. There is less said about China's own debt problem. Many local governments there are relying on sales of property in an inflated market to pay down their mounting debt. That's raising concerns about what happens if the market bursts? The World's China correspondent, Mary Kay Magistad has a second part in our story on China's real estate bubble.

MARY KAY MAGISTAD: There is a simple reason the Chinese government is reluctant to take the air out of the country's property bubble, or even to admit there is one. Tian Guoqing is an advisor to the State Council and Dean of the School of Economics at Shanghai University of Finance and Economics. He says over the past two years almost a quarter of the Chinese government's income came from land sales. This is possible because the Chinese government, while Capitalist in nature, is still Communist in name. And all land in China belongs to the people, which is to say the State. Local governments sell the right to use land, but they never give up ownership. Victor Shih, a Political Science Assistant Professor at Northwestern University, says local governments are now using property as collateral to amass huge amounts of local debt for infrastructure projects.

VICTOR SHIH: And so to repay this debt, to even pay the interest payment on this debt, you have to sell the land. Millions and millions of hectares of this land, by necessity.

MAGISTAD: Shih says local government's need to sell so much land will come at a social cost.

SHIH: They will need to force tens of millions of urban residents from their homes, bulldoze their houses, sell this land, raise the money, and repay the debt, over the next few years.

MAGISTAD: Estimates vary as to how much local debt local governments have taken on. Shih believes it's now almost two trillion dollars worth and rising. But he says with property prices soaring, and bank loans up 30% last year, the State run banks can, for now, afford to run a kind of Ponzi scheme, rolling over non-performing loans.

SHIH: You are able to make larger and larger loans, no problem. So if this company says oh sorry man I just can't pay interest payments anymore, you say no problem. Let's say you owe me $100.00, I'll give you a loan now, $120.00 loan. You use that extra $20.00 to pay me interest. This is completely not a problem.

MAGISTAD: Shih says the problem comes when there is high inflation. He says the only way China has to control that inflation is to restrict credit. Tell the banks not to lend so much anymore. When that happens, local governments will have to sell off property to come up with the cash. And if that means bulldozing entire communities, so be it. Even if many of China's 90,000 demonstrations a year are connected to exactly this kind of forced land seizure. Others say if social unrest does get out of hand, the central government, which values stability over all else, will almost certainly step in and pay down at least some local government debt. Economist Andy Xie says it will be better for just about everyone when prices come back o sane levels. But he says it might still be a year or two before that happens.

ANDY XIE: Land price can fall until the developers hand over the money. The local governments got the money, pay off their debts. Then the price can fall.

MAGISTAD: Xie says many private developers raked in profits from property sales last year and are now sitting on the cash, waiting for prices to come down. He says they don't seem to get the rules of the game. To explain those rules, he channels the voice of a local official.

XIE: The local governments need your help because I have paid all this money to resettle all these people. So you must give me the cash to bail me out. You make money because I let you make money. So it's your money only for the time being until I ask for the money.

MAGISTAD: For now. There are obvious limits to how much private developers can or are willing to absorb losses so local governments can pay their debts, especially if developers sense a property bubble is about to burst. The last time this happened on a grand scale in China, ten years ago, then Premier Zhu Rongji headed off inflation by jacking up interest rates 10 percent in one go. Property prices plummeted, in some places by as much as 90%. It's a dangerous game and now that inflation has started to creep up again, a high stakes round has begun. For The World, I'm Mary Kay Magistad, Beijing.