Fed warns ailing China real estate sector poses risks to US economy

The Federal Reserve warned on Monday that stresses in the Chinese real estate sector “posed some risk to the US financial system”, pointing to heavily indebted property companies like Evergrande as a potential source of global contagion.

“Given the size of China’s economy and financial system as well as its extensive trade linkages with the rest of the world, financial stresses in China could strain global financial markets through a deterioration of risk sentiment, pose risks to global economic growth, and affect the United States,” the Fed warned in its semi-annual Financial Stability Report.

On the domestic front, the Fed also warned that a “steep rise” in interest rates could lead to a “large” correction in risky assets, in addition to a reduction in housing demand that in turn could lead to lower home prices. Employment and investments could take a hit too as borrowing costs for business rose.

The US central bank said it was worried about China because the nation’s “business and local government debt remain large; the financial sector’s leverage is high, especially at small and medium-sized banks; and real estate valuations are stretched”.

“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,” it said.

The Fed said the Chinese financial system could come under pressure if there were “spillovers to financial firms, a sudden correction of real estate prices, or a reduction in investor risk appetite”.

The central bank’s warning came roughly two months after Jay Powell, Fed chair, described the Evergrande situation as “very particular” to China. Speaking at a news conference, Powell said he did not see a lot of “direct United States exposure” but was worried that the turmoil could have a broader effect on global financial conditions and investor confidence.

In its report, the central bank cautioned that highly indebted emerging market economies could also pose a risk to financial stability, especially in the event of a “sudden and sharp” tightening of financial conditions. These have loosened to historic levels in the aftermath of the Covid-19 crises due to the actions undertaken by central banks and other policymakers globally.

“A sharp tightening of financial conditions, possibly triggered by a rise in bond yields in advanced economies or a deterioration in global risk sentiment, could push up debt-servicing costs for EME sovereigns and businesses, trigger capital outflows, and stress EMEs’ financial systems,” the Fed wrote in its report.

“Widespread and persistent stress” could have repercussions on the US financial system, the Fed said, adding that businesses with “strong links” to the most vulnerable countries were particularly at risk.

“There was a notion of correlation [in the report],” said Padhraic Garvey, regional head of research for the Americas at ING. “The fear is that if one thing goes, the rest could go.”

In a special section of the report, the Fed also analysed “recent volatility in so-called meme stocks”. So far, it said “the broad financial stability implications of these developments have been limited” as trading volatility subsided, but deserved “continuing monitoring”.

The Fed said reasons for concern included the relatively high leverage ratios of younger investors and the possibility these would leave them “more vulnerable to large swings in stock prices”, particularly when so many market participants are trading equity options.

The central bank said it also worried that the interaction between social media and retail investors “may be difficult to predict” and that “the risk-management systems of the relevant financial institutions may not be calibrated for the increased volatility”.