Europe... The United States... China... Looks like everything’s coming down together - a slow(ish) train wreck.

China Property Dip Sparks Bank Fears

CNBC,

Published: Monday, 21 Nov 2011 | 7:16 PM ET

Originally published in the Financial Times

The number of property transactions in China’s largest cities has fallen to dangerously low levels, according to regulatory documents obtained by the Financial Times.

According to the documents, the China Banking Regulatory Commission earlier this year ordered domestic banks to weigh the impact of a 30 per cent decline in housing transactions in “stress tests” aimed at determining the health of the Chinese financial system.

While the government has been trying to rein in sky-high property prices, a Chinese real estate slump would have a significant ripple effect on the global economy. Property construction accounted for more than 13 per cent of China’s economy last year.

In April the CBRC told banks to test their loan books against a 50 percent fall in prices, and also a 30 per cent fall in transaction volumes.

In October, however, property transactions fell 39 percent year-on-year in China’s 15 biggest cities , according to government data. Nationwide, transactions dropped 11.6 percent, accelerating from a 7 percent fall in September.

The fall-off in transactions has affected developers’ cash flows and, in some cases, their ability to repay bank loans. Rising defaults after a lending surge in 2009 and 2010, much of which ended up in the property sector, were cited by the International Monetary Fund this month as one of the Chinese financial sector’s biggest risks.

The CBRC has not released the results and declined to comment. But one analyst who reviewed the stress-test documents said they did not take into account the impact that fewer transactions and lower property prices would have on bank collateral.

“If developers can’t sell property and local governments can’t sell land, it’s hard to see why banks would be any better at either task under such conditions,” the analyst said.

Chinese regulatory officials admit privately that the tests need to be improved. One senior official said banks were often unaware that loans to big state-owned enterprises had been funnelled to real estate subsidiaries, and acknowledged that the impact on collateral had not been fully taken into account.

The weaknesses in the Chinese scenarios echo earlier problems with stress testing in the European Union, where regulators underestimated the potential impact of a sovereign debt crisis.

The fear is that the impact of a bursting of the Chinese property bubble could yield a crisis just as dramatic as the one now unfolding in Europe. Rising defaults after a lending surge in 2009 and 2010, much of which ended up in the property sector, were flagged by the International Monetary Fund this month as one of the major risks hanging over the Chinese financial sector.

While Beijing’s campaign to cool the property market has had its intended effect, some analysts worry that the government has underestimated the impact its measures are having.

The measures, including higher downpayments and restrictions on home purchases, have taken nearly two years to gain traction.

But the concern is that the government will have trouble shifting gears quickly to respond if necessary. The fall in the number of in buyers is also beginning to weigh on construction, which could deal a blow to the wider economy.

Those knock-on effects were barely tested in the stress analysis. Banks were told to catalogue a series of property-related loans: to developers, for mortgages and to upstream industries like cement and downstream industries like furnishings. But the methodology imagines that while house prices drop, overall economic growth remains more or less unimpaired.

“Before property prices drop 30 percent, one needs to think how much sales are down and, more importantly, how much construction is down. Not only will that impact on steel and cement, but it also would mean a drop in industrial production, investment and jobs,” one analyst told the FT.

Another analyst said the stress tests did not do a good job of grappling with the way a property slump would ripple through the banking system by resulting in falling land sales and prices on the value of bank collateral. Yet the vast majority of collateral in the Chinese banking system is land or property, so a slump could force writedowns across the board.

“This is the key correlation risk. If developers can’t sell property and local governments can’t sell land, it’s hard to see why banks would be any better at either task under such conditions,” the analyst said.