Chinese banks: China’s banking regulator wants to show it is more serious than its European counterparts. After banks passed a test based on a 30 per cent fall in house prices, the regulator is trying to see whether lenders can handle a 50 per cent drop. Such a sharp fall, while unlikely, would be hurtful to China and the world. But Beijing deserves credit for making a stress test living up to its name.
Rising leverage has become a concern for China's banking system. China’s mortgages rose 48 percent in 2009, almost five times as fast as economic growth. Overall leverage is still low, and mortgages have traditionally been banks' safest assets. But a big increase in property prices has made buyers more stretched. Beijing's crackdown on the property sector has stoked more worries of a hard landing.
A 50 percent price drop would hit China's economy hard. Real estate investment makes up 22 per cent of China’s fixed asset investment and 10 percent of GDP, according to Merrill Lynch. A falling market would hurt demand for construction materials, and worse, dampen consumer confidence. There would be ripple effects through the global economy.
The good thing is there isn't likely to be a Chinese-made subprime crisis, even if there is a sharp correction. Banks have been demanding more than 20 percent down payments. For third homes, the banking regulator now wants a 60 percent initial payment.
Still, rising defaults may lead to a new round of recapitalisation. A 14 percent default in mortgages would wipe out Chinese banks’ 2009 earnings. But Beijing could take the hit: a 14 percent mortgage default would be only around 40 percent of foreign reserves. Bond holders should be fine, but equity investors would have to take a big haircut.
The notion that Beijing is testing such an extreme scenario makes investors nervous. But it’s at least good that the authorities are trying to prepare for the worst.