Fed Warns That Chinese Property Implosion Could Roil U.S. Economy

Chinese debt is now a significant risk to global economic growth and the U.S. economy, though not the only one.

In China, business and local government debt is large, and the financial sector’s leverage is high, especially at small and midsized banks. Adding to the risk, real estate valuations are stretched, according to the latest biennial Financial Stability Report, which was published by the Federal Reserve System on Monday.

"In this environment, the ongoing regulatory focus on leveraged institutions has the potential to stress some highly indebted corporations, especially in the real estate sector, as exemplified by the recent concerns around China Evergrande Group," the report says. 

Spillover from the real estate sector is a risk for the entire Chinese economy and, given the size of China’s economy and its trade linkages with the rest of the world, such stresses in China could strain global financial markets and affect the U.S. economy, the Fed warns.

Chinese debt isn't the only risk to U.S. growth cited in the report. Other wild cards include a possible deterioration of the public health situation in the United States, a sharp rise in interest rates and a slower-than-expected economic recovery in Europe.

Besides the sheer size of Chinese debt, another concern is assessing exactly how much of it there is, considering the various ways corporations and other entities can obscure their genuine debt loads, The Wall Street Journal reports. Evergrande’s net debt-to-equity ratio would be 177%, instead of the widely reported figure of 100%, if all its actual debt were counted, according to JPMorgan Chase. That extra total would include debt associated with commercial paper, joint ventures and other off-balance-sheet entities.

Evergrande isn't the only example of worrisome real estate debt in China. Shenzhen-based developer Kaisa Group Holdings missed a payment on a wealth-management product and plans to speed up asset disposals to meet its obligations.

Sinic Holdings Group Co. had its credit rating downgraded by S&P Global Ratings after failing to pay the interest and principal of a $250M bond. That followed a similar default by Fantasia Holdings Group Co. in October. Other Chinese developers, some with U.S. holdings, have recently sought to delay payments or otherwise mitigate their obligations.

Some investors see Chinese debt as an opportunity, however. Goldman Sachs Asset Management is now buying Chinese real estate debt, Bloomberg reports. The investor has been in the market for high-yield, dollar-denominated bonds issued by Chinese property developers, which are now trading at steep discounts.

"The breadth of distress that the market is now pricing [is] starting to look significantly out of alignment with the true extent of distress,” Angus Bell, a member of Goldman’s portfolio management team, told Bloomberg.