China’s red-hot debt market spans both the conventional financial sector and its shadow banking sector. Sparks are beginning to fly from the latter, as demonstrated by the near-failure of the 3-billion-renminbi ($495 million) Credit Equals Gold No. 1 trust, a high-yield trust that had been the province of the China Credit Trust Co. but had been distributed through the Industrial and Commercial Bank of China. ICBC had distanced itself from the trust after the collapse of the coal mining company at the trust’s heart.
Only four days before Credit Equals Gold’s maturity date, a deal surfaced to prevent its failure. But economists and analysts see danger in that bailout, believing that it will encourage even more risk taking. Already the trust market in China totals $1.67 trillion, driven by investors hungry for returns. And former Fitch banks analyst Charlene Chu, who now works for independent research firm Autonomous, has stepped up the pace of warnings she has been delivering for the past eight years about the possibility of a collapse in China’s banking sector.
Ties between ICBC and such shadow banking products as Credit Equals Gold illustrate the problem. The vast expansion of credit—between $14 and $15 trillion in just the past five years—in China means that there is a huge amount of shadow banking wealth management products, trusts among them, into which investors are sinking vast amounts of money. And because so many of those products are tied to the official banking industry, the threat is perceived as looming ever nearer, with George Soros writing a warning about China’s economy back in January and even Bill Gross of PIMCO calling China the “mystery meat of emerging-market countries.”
Not all investors, of course, have turned to such high-risk places as shadow banking vehicles to park their money. Households in China have turned increasingly to real estate, putting more and more of their net worth into the homes in which they live—and driving real estate prices ever higher. That in turn has fueled fears of another kind of risk: a real estate bubble, which, with so much of owners’ net worth bound to property, is seen as a threat to the broader economy.
Investments in real property by households looking for a better return than that allowed by mandated caps on savings have increased the already high level of household assets tied up in homes. Trusts, too, have offered entrée to the shadow banking system for those looking for a way to capitalize on the hot real estate market. Home prices are still on the rise, and some are beginning to wonder whether China’s real estate market is about to boil over—especially since reports keep surfacing of overcapacity in housing and of whole “ghost cities,” developments that are reportedly completely sold but that nevertheless are almost completely deserted.
Not so fast as the real estate market in China is different than the markets in other countries where bubbles have burst in the recent past, some experts said. Although apartment-owning urban households have sunk 75.5% of their assets into real estate and 66.1% of family assets overall were in housing in 2013, according to Henry Zhang, co-portfolio manager of the Matthews China Fund and the Matthews China Small Companies Fund at Matthews Asia, “systemic risks in China are very different than those the U.S. faced in recent years.”
Zhang said, “First, the typical down payment requirement for first-time home buyers is a hefty 30%, and usually 60% for a second home. Given such [a] high down payment requirement, the risk of default is relatively low. Second, unlike in the U.S., mortgage loans in China are recourse loans. As a result, a homeowner cannot expect that any remaining debt can be forgiven should he or she not be able to continue payments. Third, China’s debt market is still in its nascent stage, and the market for mortgage-backed securities is very small. Mortgage loans are typically kept on banks’ own books.”
That doesn’t necessarily mean that the Chinese real estate market is safe as houses. Zhang warned that the country’s real estate market “should not be viewed in isolation. Instead, it is inseparable from the whole financial system. There are a number of factors that can affect the real estate market.”
First is liberalization of interest rates, he said. “If deposit rates are fully liberalized, investors may be attracted by higher deposit rates instead of real estate.”
Then there’s liberalization of capital accounts: “If investors have more freedom in investing overseas, they will have many other investment alternatives in addition to domestic investment opportunities,” Zhang said.
Last but not least of the factors he cited is the influence of property taxes. “Only two cities, Shanghai and Chongqing, have implemented experimental property tax programs. The low carrying costs help explain why some flats sit vacant—the need to find rental income is much less pressing than it might be in the U.S., where you have to cover higher mortgage costs and property taxes,” Zhang said. These factors may not necessarily cause an abrupt decline in the real estate market, but they should help the whole financial market become more rational and efficient, he said.
Still, wary investors might want to remember that, should a correction occur in China’s real estate market, there are a few other factors that could weigh heavily on the results. First is the wealth effect. If Chinese homeowners perceive that their homes are worth less because of a drop in prices, they could cut back on spending, since so much of their wealth is tied up in those homes. That could contribute to a further slowing of the economy.
Then there’s the involvement of foreign investors, who could bail from real estate investments, whether via shadow banking products or conventional exposures, should the market appear to turn. That would pull money out of China’s economy and could end up requiring some sort of intervention by the Chinese government.
And third is the increasing exposure of foreign institutions to the Chinese economy and any potential problems through mainland borrowers’ growing use of offshore dollar funding.
If doomsayers are correct and problems are in the wings, the effects will be felt a great deal farther afield than China’s borders.