The budding crisis that could tank China's economy

As China's economy slows, financial officials in the People's Republic are taking action to prevent its overheated real estate sector from collapsing.

China's central bank reversed policy this week and loosened mortgage lending standards in hopes of shoring up the country's slumping housing market.

The move comes after the government on Tuesday reported that new housing construction fell 25 percent in April from the year-ago period. At the same time, property sales fell 14.3 percent and land sales plunged 20.5 percent. Even more worrying, nearly every other indicator of economic growth was also down last month.

In a statement on its website, The People's Bank of China told 15 banks to "improve efficiency of service, give timely approval and distribution of mortgages to qualified buyers." It also pressed lenders to give priority to families buying first homes and increase monitoring of credit risks.

Real estate is a huge part of China's economy, accounting in official tallies for some 10 percent of Gross Domestic Product. But Societe Generale economist Wei Yao says the sector is even more important given the economic linkages with other industries in China.

"Its share in total output is easily 20 percent, if its pull on related upstream and downstream sectors in included," she said in a client note. "And its significance to the financial system is far beyond banks' mortgages and direct lending to developers."

Wei said mortgages and direct lending to developers in China account for $2.4 trillion of debt held by banks. Developers' borrowing in the shadow banking system, or largely unregulated capital markets, could amount to another $1 trillion in debt. Wei estimates that more than $1.6 trillion of other types of corporate borrowing is collateralized with real estate. Meanwhile, local governments have used future revenue from the sale of land-use rights as collateral for another $1 trillion in loans.

Chinese housing prices have soared over the past 20 years, fueled by the government's giant infusions of cash into the system and by low interest rates.

"The short-term cycles of China's housing market, like housing markets in many other countries, are first and foremost a credit phenomenon," Wei said. "If the authorities decide to use another credit binge to inflate the sector again, they will merely make the structural imbalance between supply and demand worse."

Starting in 2010, the Chinese government has taken increasingly aggressive steps to rein in real estate prices and development. But these efforts came to late to prevent a housing bubble, and it remains to be seen if authorities can soften the broader economic impact of a decline in real estate.

"China has most likely significantly overbuilt, with per capita living space already among the highest in the world," according to Bank of America analysts. "What will prompt us to change our negative view on the market is if the government undertakes drastic measures to write off debts, recap the financial system, reduce interest rates (possibly devalue the Chinese Yuan) and shut down excessive capacities, so the corporate sector can earn their way back."

Analysts estimate there are at least 10 million unsold housing units on the market in China; still, developers have continued to build more units.

Even as China seeks to normalize its housing sector, the country is also trying to support economic growth by continuing what amounts to the largest mass migration in human history. In March, the government announced a new urbanization plan to boost the number of Chinese living in the nation's metropolitan regions over the next six years from the current level of roughly 54 percent to 60 percent. According to Citi Research, a division of Citigroup (C), that could generate as many as 110 million new jobs in China's urban areas.

An estimated 260 million people are expected to be relocated from China's countryside to one of 21 "mega regions" within the next seven years, at a tab of nearly $7 trillion.

Despite this ambitious modernization plan, Mark Williams of Capital Economics thinks demand for housing could flag in China in the years ahead. That would put even more downward pressure on real estate prices, with potentially devastating effects on the Chinese banking system.

"Contrary to many suggestions, urbanization will not drive ever increasing demand for new housing," he said in a research report. "In fact, the urban population is set to grow by less over the coming decade than over the last."

Indeed, Chinese developers appear to be using the promise of future revenue from the sale of new housing units as collateral for loans to pay off existing loans. The Chinese government has been notoriously averse to letting large businesses default on their loans, so many lenders see an implicit state-guarantee for large loans.

David Stockman, former budget chief under President Ronald Reagan, writes in his blog that China's economy is flashing red.

"China is a nation that has gone mad building, speculating and borrowing on the back of a credit bubble so monumental (and dangerously unstable) that its implications are resolutely ignored by observers deluded by the notion that China embodies a unique economic model called 'red capitalism.'"