(Bloomberg) – Just a few weeks ago, Wall Street analysts and central bankers quickly assured investors that a collapse of the China Evergrande group wouldn’t be Lehman for a while. Beijing regulators have said the crisis will be “contained.”

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Now that a massive bond sell-off has spread to the entire Chinese real estate industry, concerns are growing about the potential risk to the global financial system.

The US Federal Reserve made the link explicit in a report on Monday, warning that what is happening in China’s real estate sector could impact financial markets and threaten global economic growth. Highlighting the risks of a potential spillover, the Hong Kong Monetary Authority has asked banks to disclose their exposure to Chinese real estate, according to a local press report.

At the heart of the bond market debacle is the fear that promoters have much higher debt than shown on their balance sheets. This is after some companies struggled to pay their public and hidden debts when they appeared to have sufficient capital. To make matters worse, developers are unable to renew their maturing debt due to soaring borrowing costs that effectively shut them out of the dollar bond market. The 10 largest Chinese developers by sales owe a combined liability of $ 1.65 trillion.

“China appears to be stress testing its financial system,” said Larry Hu, head of China’s economy at Macquarie Group Ltd. to manage. But the danger is that China decides to relax too late. “

The lack of liquidity is getting worse by the day. The yield of a Bloomberg index of unwanted Chinese dollar bonds – dominated by real estate companies – jumped to 24%. The liquidation spread to high-quality issuers such as Country Garden Holdings Co., while even a company controlled by the Chinese government saw its bonds collapse.

Equities are also plunging. A Bloomberg index of Chinese developers is at its lowest for more than four years after losing 34% in 2021. Shareholders in companies such as Evergrande, China Fortune Land Development Co., China Aoyuan Group and Yuzhou Group Holdings Co. are sitting. on losses exceeding 70%. The gauge is valued at just 0.3 times the book value, showing that traders are giving a large discount to assets reported by developers.

There are few signs that policymakers will ease restrictions on the real estate market, despite the risks to the economy. Guo Shuqing, the head of the country’s banking regulator, called real estate the “biggest gray rhino” to China’s financial stability a year ago, referring to a significant but overlooked threat. President Xi Jinping appears determined to rise to the challenge as he seeks to bring “common prosperity” and secure a third term to extend his indefinite rule.

The stakes are high. Chinese banks had more than 51.4 trillion yuan ($ 8 trillion) in loans outstanding to the real estate sector in September, an increase of 7.6% from the previous year. The exposure was more than any other industry and accounted for about 27% of the country’s total lending, according to official data. About 41% of the assets of the Chinese banking system were directly or indirectly associated with the real estate sector at the end of last year.

“We expect most of Beijing’s real estate restrictions to remain in place for some time, with the worst likely to occur for both the Chinese real estate sector and the macroeconomics,” Nomura International economists wrote. HK, Ting Lu and Jing Wang, in a note released Monday. “Beijing policymakers may choose to increase their support to avoid worsening defaults in the coming months.”

Some see the massive sale as an opportunity. Goldman Sachs Asset Management has added a “modest amount of risk” through high yield dollar bonds issued by Chinese real estate developers, said Angus Bell, member of Goldman’s portfolio management team. The market overestimates the risk of contagion, Bell said in an interview last week.

Yet central bankers are starting to sound the alarm bells. Hong Kong banks will be required to disclose their loans and credits to mainland developers, the securities holdings of cash units as well as the proportion of their assets exposed, the Hong Kong Economic Journal reported, citing unidentified people.

“Financial strains in China could strain global financial markets through worsening risk sentiment, pose risks to global economic growth and affect the United States,” the Fed said in its semi-annual stability report financial statement released on Monday.

The warnings go both ways. Policymakers in China this year have blamed post-pandemic liquidity released by central banks elsewhere for inflating prices. The banking regulator said in March that asset bubbles in foreign markets pose a risk to the global economy and could burst soon.

China blows up one of the world’s most lucrative bond bets

For now, limited signs of contagion in mainland financial markets give Chinese authorities an opportunity to maintain their restrictions on the real estate sector, meaning the likelihood of some sort of Lehman moment remains low.

The economy is still expected to grow 8.1% in 2021, while the Shanghai equity benchmark is less than 6% of a six-year high. Money market rates are moderate as the People’s Bank of China ensures that there is sufficient liquidity in the banking system. The yuan is close to the strongest against the dollar since 2018.

But the way Beijing handles its crackdown on the country’s real estate sector can have far-reaching consequences beyond its borders.

“Even though the systemic risk remains low at the moment, the risk of contagion is very real,” Macquarie’s Hu said. “I would say China needs to act if the onshore markets panic and the economic risk becomes so great that they cannot defend 5% growth next year.”

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