Worthy of trust?

Beijing has been in a testy mood, seemingly much less convinced of the health of its own economy than many observers. Early August brought with it news of severe stress tests for Chinese banks, under which lenders were asked to simulate the effects of a 50-60% reduction in property prices. The goal of the tests was to better understand the effects of such a drop on developers’ finances – and what it would mean for the banks themselves.

It was not the first time this year banks had been asked to simulate such a scenario. In May, banks conducted and passed tests measuring the effects of a 30% drop in property prices.

But Beijing appeared unimpressed by that favorable result, and amid signs of a still-hot property sector has chosen to continue efforts to keep the market in line: restricting third-home mortgages, looking into developers’ land banks for signs of idle land, tightening borrowing requirements for lenders and talking of increasing down-payment requirements. The more severe test was a variation on this theme.

The market’s reaction was predictable, with property and banking stocks particularly hard hit. The China Banking Regulatory Commission (CBRC) rushed to reassure investors, noting that "stress tests are one commonly used method by commercial banks to manage risk … [They] do not represent judgments of the trend in real estate, nor do they represent possible changes to real-estate policy."

While certainly true, the CBRC’s statement is disingenuous. It may be possible to explain away a single stress test as a simple risk management tool, but their number and frequency suggests the regulator has more than just a passing concern about the potential popping of the real estate bubble. At the same time, the markets shouldn’t read too much into the possibility of a bank collapse.

In reality, some kind of property market correction is likely and even imminent, especially in first-tier markets. Property appears to be suffering from a combination of high prices and excessive supply: More than 90% of respondents to an unscientific but telling poll on internet portal Sina.com (SINA.NASDAQ) said their cities of residence had "outrageously high" rates of sold but unoccupied properties. In addition, official data show that the area of unsold housing is rising: The National Bureau of Statistics said that as of June 30, China had 191.82 million square meters of unsold housing area, up 6.4% year-on-year. Even so, prices in 70 major cities increased by 10.3% in July from a year earlier – a lower rate of growth than has been seen in six months, but still too high for Beijing’s comfort.

Given the importance of the property market to the economy, Beijing cannot allow it to experience a full-on crash. This provides a key to the reasoning behind the stress tests: By signaling its concern and intimating that it might step in, Beijing can keep speculation under control without resorting to broad tightening. It frequently uses this approach of telegraphing its punches to counter the market’s worst tendencies.

This is all well and good, but it is also a distraction from what remains a critical and systemic problem in China’s financial sector. The market’s panicked reaction to news of the stress tests aside, very few investors, when pressed, seriously believe that Beijing will allow its big banks to fail. There is too much at stake, not just economically, but politically. With no little justification, investors – and the banks themselves – can be certain that Beijing will step in to bail out lenders in any crisis.

The result is real moral hazard that will continue to thwart Beijing’s attempt to modernize its financial system. Developers, investors and banks will be emboldened to ignore warnings, both direct and indirect, and pursue short-term profits at the cost of sustainable growth. At some point, warnings and telegraphed punches will not be enough. The government will be forced to regulate – and much more severely than it might like.

Unfortunately, the choice is not an easy one: Maintain the status quo and encourage continued excesses, or change and risk a severe short-term correction. China’s goal should be to find the elusive middle path, but it does not have the luxury of time.