Three growth risks for China

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The Chinese government realized this and starting in March of this year, they enacted various tightening measures in the real estate market. In response, real estate prices have fallen from the peak in February. However, the risk is that the government overdid their contractionary policies and, going forward, prices could fall too fast leading the property sector to crash. 

One mitigating factor is that unlike the U.S., real estate loans only account for about 13 percent of total oustanding loans in China's banking system, said PNC.

Local Government Borrowing

PNC warns that data on local government projects may not be the most accurate and reliable in the world, but evidence strongly suggests that there is a problem.

The issue is that banks lent lots of money to local governments for fee-generating infrastructure projects. However, right now, it looks like many of these projects cannot collect nearly enough revenues to pay back the loans. In fact, many of them cannot even cover operating expenses.

Unlike their U.S. counterparts, Chinese local governments don't have many options to raise revenues. According to PNC, their main source of revenues is transfer payments from the central government and land sales. Therefore, it seems that banks are stuck with these non-performing loans.

One positive feature is that Chinese banks are raising capital, as evidenced by the Agricultural Bank of China's recent record-breaking IPO. However, there are massive amounts of these loans to government – one estimate put it at 11.4 trillion RMB, or roughly 1/3 of China's 2009 GDP – and Chinese banks are probably more exposed to them than the residential real estate sector.

Policy Mistakes

The Chinese government may have a good economic track record, but they are by no means perfect. 

Th government makes mistakes in capital allocation. At least two towns in which the Chinese government has spent billions of RMB on have essentially been abandoned. The government also built the largest mall in the world, which is currently 99 percent vacant.

China is trying to shift its economy from investment and exports to more consumption. The government has raised wages and signaled a more flexible attitude towards the yuan. It must also address the fact that households can only channel their savings into three sectors, namely domestic stocks, bank deposits, and real estate. This partially explains the rampant speculation in real estate.

These two much-needed policy shifts are rather complex and difficult to navigate, leaving even the Chinese government open to mistakes and unintended consequences.