The recent inflationary increase in property prices is the greatest risk that China faces today. Anecdotal evidence indicates that price increases have reached 50 percent or more in cities like Shanghai and Shenzhen.

It is difficult to assess the magnitude of the risk, since reliable data that are controlled for location and quality are hard to obtain. It is possible that property price increases are justified by fundamentals, or by "real demand" for owner-occupied housing.

However, it is more likely that the very high prices are caused by speculative investment. Demand has been created by expectation that the prices will continue to rise rapidly, so that investors can pocket profits from selling in the near future. Such speculative demand results in actual price increases, confirming expectation.

This process is known as a bubble. A bubble eventually collapses, resulting in losses for speculators, developers, and banks who lend to them.

The Japanese economy went through one of the largest property bubbles in history in the last quarter century.

Sharp increases in property prices for five years in the second half of the 1980s were followed by steady declines for fifteen years. The land price index tripled in five years. The price index for residential land in six large cities rose from 39.2 in September 1985 to 105.8 in September 1990. The commercial land price index rose from 27.9 to 104.5. Land prices first rose in the central part of Tokyo, then spread to first-tier suburbs, then to smaller cities and second-tier suburbs, and finally to rural areas. They were fueled by the easing of monetary policies and optimistic expectations of the future of the economy.

When property prices, along with stock prices, started to fall in 1990, the speculative process reversed. The painful, long stagnation of the economy was marred by a series of banking crises that were mostly caused by mishandling of non-performing loans to the real estate sector.

How similar is China today to Japan in 1989? There are many similarities and common factors.