Contagion fears: China’s property implosion has the US on edge

Implosions within China’s gigantic real estate development sector have generally been viewed as an internal problem, albeit with implications for China’s broader economy and growth rate, and thus with some repercussions for the rest of the world.

However, the US Federal Reserve Board has raised the possibility that tensions within China’s real estate markets, coupled with a tightening of global financial conditions that could particularly affect highly indebted emerging economies, could pose a risk to the US.

In its biannual financial stability report released on Tuesday, the Fed said China’s commercial and local government debts remained large; the leverage of its financial sector was high and real estate valuations were stretched.

“In this environment, the ongoing regulatory focus on leveraged institutions has the potential to stress some highly indebted corporations, especially in real estate, as evidenced by recent concerns around the Evergrande Group of China,” he said.

“The tensions could, in turn, spread to the Chinese financial system through contagion effects to financial firms, a sudden correction in property prices or a reduction in investors’ appetite for risk.

Given the size of China’s economy and financial system, as well as its extensive trade links with the rest of the world, financial stress in China could put pressure on global financial markets through a deterioration in risk sentiment, raising risks to global economic growth and affect the United States. State “.

Tensions within the ranks of Chinese property developers have spread beyond Evergrande, although it remains the largest of the struggling developers. At least half a dozen of the largest developers have not paid the interest or principal on their bonds or wealth management products.

Yields on high- and low-rated Chinese bonds have soared as high as 25 percent, after falling below 10 percent in the middle of the year, in an indicator of a broadening of the perceived risk of holding Chinese junk bonds.

Real estate developers have more than $ 200 billion ($ 271 billion) in US dollar-denominated bonds outstanding in a foreign bond market essentially closed to new property-related issues.
Authorities are directing those who have the cash to prioritize meeting their pre-sale commitments by completing developments on meeting debt obligations. His troubles and falling property prices have cut off the supply of another source of cash and liquidity from the new presales.

While more stressed developers like Evergrande have been able to avoid formal defaults so far, with Evergrande collecting some cash to make late interest payments, new payment obligations keep popping up.

Evergrande, for example, has payments on three-dollar bond issues that are due this week after their 30-day grace periods have expired. If it defaults on those payments, it could trigger cross-default provisions within the more than $ 19 billion in bonds it has issued.

The size and importance of the real estate sector within China, its indebtedness; Aside from bond issues and shadow bank debt, Bloomberg has estimated that Chinese banks are exposed to developers to the tune of about $ 8 trillion, or nearly 30 percent of their total. loans and the extent to which property values ​​have been inflated means it is an obvious threat to the stability of China’s financial system and economic growth.

Developers are being cut off from dollar bond financing, from pre-sale financing, from cash raised through shadow banking channels and forced to dedicate the cash they have to complete projects for which they have already been paid.

Add in the tighter controls on loans and loans against property that have been imposed by the authorities and the ingredients for something rather nasty are in place.

The authorities have expressed confidence that the risk of the sector’s problems becoming a broader threat to the financial system is controllable, but they do not appear to be doing anything substantial to control them, focusing more on protecting buyers and suppliers of homes than in isolating consumers. a broader system against risk.

The Fed is now saying that domestic tensions could be transmitted outside of China and be of sufficient magnitude to pose risks to systemic stability and growth elsewhere.

On its own, a collapse in the domestic property market is unlikely to have systemic implications for developed economies elsewhere, although a consequent slowdown in China’s overall growth rate would have flow effects, particularly within Asia.

Losses to foreign investors in Chinese stocks and bonds would be significant, but not enough on their own to shake up the United States or other major financial systems.

However, if a housing market collapse coincided with a general tightening of global financial conditions, the Fed’s concerns about China and emerging market economies could come true.

Globally, conditions are hardening. Central banks are beginning or are close to reducing the monetary policy stimulus they provided in response to the pandemic. Interest rates worldwide are rising. The unprecedented levels of fiscal stimulus that triggered the pandemic are being withdrawn.

Financial markets are sensitive to ongoing changes and the potential, caused by levels of inflation not experienced for decades, that ultra-low interest rate safety nets and abundant liquidity provided by central banks since the 2008 financial crisis be taken from below them.

The Fed report noted that a sharp rise in interest rates could lead to a large correction in the prices of risky assets and stresses within financial institutions, businesses, and households.

It wouldn’t take much under these circumstances for a spark in China to trigger a global sale of inflated assets.

The Chinese authorities detest any kind of economic or financial instability, considering it a threat to political stability. They can still act to ensure that the risks to China’s growth and stability, and the growth and stability of other economies, emanating from its real estate sector, are contained and defused.

It remains unlikely that China’s real estate problems can create a “Lehman moment” on their own, but the fragility and vulnerability of global financial environments as the world try to migrate away from monetary and fiscal policies inspired by The pandemic, even when inflation rates remain high means that possibility cannot be completely ruled out.

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