The Federal Reserve warned on Monday that the Chinese real estate sector jobs “poses 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.

Domestically, the Fed warned that a “steep rise” in interest rates could cause a “large” correction in risky assets, as well as a reduction in housing demand, which could lead to lower home prices. As business borrowing costs rise, employment and investment jobs may suffer as well.

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 warned that “spillovers to financial firms, a sudden correction in real estate prices, or a reduction in investor risk appetite” could put pressure on the Chinese financial system.

The central bank’s warning comes roughly two months after Fed Chair Jay Powell described the Evergrande situation as “very specific” to China. Powell said at a news conference that while he did not see much “direct US exposure,” he was concerned that the turmoil could have a broader impact on global financial conditions and investor confidence.

“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.”

The Fed also examined “recent volatility in so-called meme stocks” in a separate section of the report. So far, it has been stated that “the broad financial stability implications of these developments have been limited” as trading volatility has subsided, but that “continuous monitoring” is required.

The Fed expressed concern about younger investors’ relatively high leverage ratios, which could leave them “more vulnerable to large swings in stock prices,” especially when so many market participants are trading equity options.

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

Source: Financial Times

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