The probability that a real estate bubble may burst in China is rising. The financial sector heavily depends on real estate, which in turn exposes the entire Chinese economy to systemic risk. This link means that a downturn in real estate could soon spread to other areas of the Chinese economy if banks face liquidity shortfalls.

Also, falling housing prices could result in more non-performing loans (NPLs). While NPLs officially account for only 1.75 percent of all Chinese loans, the government is likely understating the figure. BMI Research, a financial consulting firm, estimated in a 2016 report that NPLs could be close to 20 percent of loans.

As banks gave more credit to real estate developers and buyers, their profitability stalled. In theory, China’s economy is not based on capitalism and thus doesn’t revolve around profitability; but in practice, money needs to come from somewhere. A company that doesn’t make a profit can’t survive in the long run. The Chinese government can’t afford to let banks fail since it would threaten both the financial system’s health and the key lifeline to state-owned enterprises that provide jobs.

This surge in China’s real estate prices, fueled by ongoing credit expansion, are forcing the government to choose between deflating the housing market and slowing growth.

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