5 Reasons China's Bubble Will Burst

China raised a key interest rate for the third time this year as the country deals with surging inflation.

That the benchmark rate for one-year loans will be raised 0.25 percentage points to 6.56 percent is not such a big deal at face value. The country's interest rate is still manageable. It's the reason China has had to bump up rates a third time this year, just halfway through the year, that's alarming when combined with other pressing problems the world's second largest economy faces.

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Here's five reasons why China's fast-growth economic bubble will burst:

Inflation is Gaining Momentum

Inflation in China hit a 34-month high of 5.5 percent in May, and economists think it rose even higher in June. Let's not forget, either, that China is a communist country and the government shades realities to the positive side. All economic growth figures and inflation figures should be adjusted in a more negative direction. Thus, China's true inflation rate is probably running at about 7 percent -- a dangerous figure for such a large country with wage-growth imbalance. Global food prices are rising and China needs a lot of food. Housing costs are rising, also. But wages are not growing that fast throughout the country to keep up.

China has a Credit Bubble

Private sector forecasters say the mix of rapid growth and higher inflation in China means Beijing should further tighten access to credit. We know in America all too well what happens in too much credit is extended when asset values are inflated and wage growth sustainability is not a reality.

Pop goes the bubble.

Already, China faces massive debt problems in local governments throughout the country. In June, China's communist government announced that local governments in the country have piled up debts of $1.6 trillion, raising concerns of banks' health in the nation if the loans can't be repaid. The money was borrowed by local governments throughout the country during the boom period of the last decade as China's economy has emerged fast to become the world's second largest, bypassing Japan, to pay for construction and other spending. That means much of China's growth has been falsely stimulated, which means it's a bubble.

Even the government has concerns.

Due to inadequate repayment ability, some local governments can only pay their debts by taking on still more debt, stated a report provided by China's National Audit Office.

A Real Estate Bubble Looms

As if it's not bad enough already with inflation and debt-ridden local governments, China is in the midst of a massive housing and commercial real estate bubble that is not sustainable. What goes up must come down, after all, no matter what the most hopeful bullish China investors say.

Consider only the words of renowned short seller Jim Chanos, the hedge fund manager who correctly called the implosion of Enron, Tyco, and sub-prime mortgages while the rest of Wall Street continued to pour money and praises upon both. Chanos appeared on Bloomberg's Charlie Rose program late last year and said China was on an economic treadmill to hell.

Chanos began questioning China's economic foundation as early as 2009, when one global company after another was at the height of pouring billions into the economy through partnerships with the country's communist government. He told Fortune he and his company began looking at commodity prices and the stocks of big mining companies. The result: Everything we did in our microwork (on commodities) kept leading us back to China's property market.

Chanos recalled being at a research conference in 2009 when an analyst enthusiastically cited numbers of China's robust building boom, noting that the country was experiencing building at a pace of 5 billion square meters of new residential and office space, on top of all that had previously been constructed in the country during its emergence over the past decade and before the globally-hyped Beijing Olympics.

Chanos did some math. He calculated the pace would result, divided by China's population of 1.3 billion people, at what amounts to one five-by-five cubicle for every man, woman, and child in the country. That's when he began to play the drumbeat of a contrarian, stating flatly he sees China heading for economic bust.

He was right about Enron and Tyco and sub-prime mortgages, and he'll be right about China, too.

Wage Growth Will Slow

Personal income in China has been increasing at an estimated rate of 6 to 10 percent, according to estimates. The rise is directly attributable to the country's economic emergence, rising in the past year to become the world's second largest economy. But cheap labor made China an economic power and cheap labor will keep it that way. As businesses face rising costs, they'll do just as western companies do, and look to the one of the biggest cost areas to cut and control -- labor.

The Government Can't Solve All Ills

Some bullish-on-China observers who admit the country is in the midst of an economic bubble suggest there's little danger with China since the communist government will merely do all required to overcome the problem, at any cost.

Peter Morici, a public policy professor at the University of Maryland, addressed this very issue in an interview with CNNMoney, noting that China could easily buoy its economy should conditions worsen, flooding the U.S. market and world with extremely cheap stuff to provide domestic stimulus support. Although that equation doesn't address rising wages in China that may make such a move more difficult in the future as it was in the past, Morici was convicted that China's ability to make cheap goods, shipping them to the U.S. and throughout the world, provides the country distinct advantage.

Remember, he said, when we talk about bubbles, the stakes are the future of the communist party. They'll try to survive no matter what; and it could mean destroying other economies to do it.

Try is the operative word.

No question China's government will do all it can to avoid a complete economic meltdown, but let's not forget that while the steps are small compared to what most want, China has become more economically westernized through its growth period than what it once was. The more it mingles financially with the rest of the world, the harder it will be for the government to falsely buoy a bust.

Also, the argument that the government will just make a bunch of cheap goods and flood the market means wage growth in China will slow -- a problem in an inflationary environment.

That's why China's economic will burst sooner and with more harsh impact than many expect.

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