It's difficult to determine how exposed Chinese banks are to real estate debt because loans booked to some state-owned companies as industrial lending may have been used to invest in property, say Xie and Charlene Chu, who analyzes Chinese banks for London-based Fitch Ratings Ltd. in Beijing.

A downturn in the property market may be accompanied by a surge in nonperforming loans. The Shanghai office of the banking regulatory commission said on Feb. 4 that a 10 percent fall in property values would triple the ratio of delinquent mortgages there.

Shares of Industrial & Commercial Bank of China Ltd., the world's largest bank by market capitalization, are down 13 percent this year. China Construction Bank Corp., the second- largest, has fallen 10.2 percent. Both are based in Beijing. The Shanghai index is down 9 percent.

Fund manager Joseph Zeng says he has a contrarian view on China's banks, on the grounds that rising interest rates this year will benefit their net interest margins.

Economic Cycle
"For us, non-performing loans are not expected to be a big issue until 2013, the peak of the current economic cycle," said Zeng, head of Greenwoods Asset Management Ltd.'s Hong Kong office, in a phone interview. He declined to say what he is buying. Greenwoods has more than $500 million under management.

China has firepower to deal with a crisis. The nation has the world's largest foreign exchange reserves, at $2.4 trillion, and government debt of only about 20 percent of GDP last year, according to the International Monetary Fund. That compares with 85 percent in India and the U.S. and 219 percent in Japan.

CB Richard Ellis doesn't count empty office buildings bought by banks and insurance companies when calculating vacancy rates, since some of the space is for the owners' use. The Los Angeles-based company said in a report that vacancy rates are starting to fall and rents to rise for the best office buildings as China's fast economic growth buoys demand.

Gross domestic product expanded 10.7 percent in the fourth quarter from a year before, a two-year-high, after the government introduced a $586-billion stimulus package.

Full Buildings
"In many cases when you look at these buildings and say, that's never going to be fully occupied, somehow 12 to 18 months later the building is full," said Chris Brooke, CB Richard Ellis's Beijing-based president and chief executive officer for Asia.

Overcapacity may be looming in manufacturing as well. China's investments in new factories and properties surged 67 percent last year to 15.2 trillion yuan, more than Russia's gross domestic product. Excess steel capacity may have reached about 132 million tons in 2009, more than the 87.5 million tons from Japan, the world's second-biggest producer. The Beijing- based EU Chamber of Commerce report said a "looming deluge" of extra cement capacity is being built.

While neither Xie nor Chu see nonperforming loan ratios reaching the level of a decade ago, when they made up 40 percent of total lending, they say banks will see deterioration in their balance sheets.

Losing Money?
"A lot of people will lose a lot of money, but the banks will probably not go down like in the 1990s," Xie said in a phone interview. "Of course there will be a lot of bad debts. There will be a lot of mortgages gone bad I think."

Eoin Treacy's view The Chinese economic success story has until now been predicated on huge investment in fixed assets, low cost manufacturing and easy of access for foreign investment. The road, rail, port and air networks in today's China rival and often exceed those of other industrialised countries. While China still has further progress to make in delivering infrastructure, particularly in water and environmental management the question is now whether fixed asset investment is the most cost effective method of delivering the growth needed to fuel the country's development.

The Chinese authorities have stated they want to see the country's manufacturing base move up the value chain. Part of the overall strategy remains to create domestic demand for consumer goods in order to provide a cushion from external shocks. This will only be possible if the government can provide a higher degree of confidence among the population that they have less need to save such a high proportion of their income. In this regard, no one expects the Chinese to adopt profligate consumption but a more realistic target would be to approximate the consumption of populations in Hong Kong, Taiwan or Singapore which share a common culture.

There appears to be growing acceptance at government level that the policy of growth through fixed asset investment has reached a level where the return on investment is no longer competitive with what can be attained through promoting the consumer economy. The last few months have seen a number of announcements along these lines. Plans are now underway to allow a large number of migrant workers claim domicile in cities, thus expanding the reach of the social security network. Simultaneous increases in spending on healthcare are also an important indication of attempts to free up the need for such high savings rates. Here is a section from an IMF report on this subject posted in Comment of the Day on January 22nd:

The main finding of this paper is fairly robust. Higher government health spending reduces urban household saving and suggests that broadening coverage of public health care could have an important effect on household precautionary savings. The magnitude of the impact, moreover, is quite large and suggests that each additional yuan in government health spending boosts urban consumption by 2 yuan. For rural households, with the exception of those in the higher income provinces, there is, however, no evidence of a relationship between government health spending and saving.

There was also no evidence that higher government education spending has an impact on either urban or rural saving. This is not entirely surprising, as the precautionary saving motives are likely much higher for health than education. In both cases, an increase in government spending has competing effects on saving. First, it could increase saving by substituting public for private provision of the services, thereby freeing up household resources of which some would be saved. To reduce saving, government education or health spending would need to have an additional effect, such as reducing precautionary saving motives. Given that a large part of the savings are being generated by older generations, who are more likely to need to save for healthcare costs rather than education for their family members, it is sensible to expect that improvements in public health care are likely to have a more potent effect on household saving behavior than expanding publicly provided education.

Although past rural health care spending appears to have had little impact on consumption, the government's new health reform strategy for 2009-11 has the potential to improve health outcomes and raise rural consumption. The government has given priority to the health sector, along with other social sectors, such as education and social protection, in the 11th five-year plan. A comprehensive study by the World Bank (2009) suggests that while progress is being made to improve China's rural health system, including by marching quickly toward universal coverage for rural areas, a number of challenges remain.

Importantly, the study notes that the inequalities in China's health system reflected, at least in part, inequalities in government health spending. They note that government health expenditure disproportionately benefited the better off. This reflects the fact that over half of general government health spending supports urban insurance schemes whose members are disproportionately from higher income groups, even within urban areas. The reorientation of government spending toward the poorer rural areas and increased efficiency in the delivery of public health care will be key factors in improving health outcomes and impacting consumption behavior.

High commercial property vacancy rates are a potential short-term issue and could be a drag on the banking system if defaults rise. The continued tightening of reserve requirements by China indicates that they are acting to prevent a runaway property bubble which is to be welcomed, although these actions may cause short to medium-term pain for overleveraged property speculators. However, if efforts to grow the consumer economy succeed, and the Chinese have a sound record on successfully implementing large macro projects, then demand for retail and commercial space should increase as a result.

There are competing arguments about whether China will be successful in evolving from a fixed asset investment, low end manufacturing model to a consumer driven, high end manufacturing centre. This isn't a debate which is ever likely to be settled by some of China's most virulent critics, however the trend points towards a long-term success story. The ranging consolidation currently evident in the stock market suggests that supply and demand factors are currently in relative equilibrium which is a reflection of the balance of current sentiment towards the country's markets. Provided the Shanghai A-Shares continues to hold in the current range we can continue to give the benefit of the doubt to the overall bullish hypothesis.

Mrs. Treacy and I will be taking our daughters to Beijing this June to visit family and I look forward to refreshing my impressions of China's economy first hand.