Credit conditions in China warrant special attention in light of the country's considerable size and systemic importance to the global economy.

The property and credit markets in China represent potential vulnerabilities in an environment of decelerating—albeit still good—growth. In part because of administrative measures intended to prevent or deflate property bubbles, house prices in most Chinese cities have been moving downward since 2008 and appear to have recently bottomed. (See Figure 1.)

Housing affordability is still stretched. While most market participants think price declines have ended or bottomed, some analysts believe housing prices may resume their fall. If prices have bottomed, pressure will be taken off property developers, local governments relying on land sales for revenue, and other exposed sectors. (See Figures 2 and 3.) With real estate investment accounting for 13% of economic output and about 20% of bank loans, if housing prices resume their decline the housing sector could have a strong negative effect on the quality of bank assets.

China is already at an advanced stage of the credit cycle. As a result of stimulus measures adopted in response to the global credit crisis, overall credit in China (according to the IMF) has grown at an average annual rate of more than 25% from 2009 to 2011, bringing the overall credit-to-GDP ratio above 150%. Christopher Woods of CLSA Securities wrote: "The latest China credit data is far from disastrous. But it also does not end growing concerns about a credit trap. Thus, new lending totaled Rmb704 billion in August or Rmb6.1 trillion in the first eight months of this year, accounting for 76% of the annual target based on the assumed Rmb8 trillion credit quota. Still, the most concerning point remains the substantial amount of loans accounted for by short-term lending and bill financing. Thus new short-term loans and bill financing totaled Rmb398 billion in August and Rmb3.88 trillion year-to-date, accounting for 57% of total new lending in August and 64% year-to-date, compared with 50% in 2011 and only 20% in 2010."

Another concern with China's credit recovery is evidence of capacity constraints in the banking system. While loan growth has been increasing, it appears to be hampered by a lack of liquidity. For instance, weak deposit growth across the system, high loan-deposit ratios outside the major banks, and binding regulatory loan-deposit ratio requirements, as well as high reserve ratio requirements, are soaking up liquidity.

Stress tests by the Chinese authorities (conducted with the IMF and World Bank) suggest that, in a tail-risk scenario with weak growth and plunging house prices, non-performing loan rates could rise to as high as 8%. While China has the financial resources to recapitalize domestic banks facing difficulties, incipient problems with credit quality would likely deter authorities from repeating the 2008 to 2009 strategy of rapid domestic credit expansion.

The chief risk we see to credit conditions in China is a lack of follow-through in terms of improving credit conditions. Current monetary policy appears to favor loosening and credit demand appears to be real, but the recovery of credit conditions ultimately rests on the system's ability to sustain lending.

We agree with Morgan Stanley and other firms that credit conditions have been improving and that China's muted growth recovery could mean further policy easing. Several investment firms have written that if the current positive monetary conditions continue and China credits see supportive technicals and attractive valuations, China credits will become or are already the best opportunity in Asian credit markets today. We caution investors, however, that given the continued systemic risk in the global financial system, e.g. the ongoing issues in the Eurozone, they may want to seriously consider high-quality credits and possibly high-quality property credits as potential investment vehicles.

During this period of uncertainty, investors have shied away from China funds despite fairly robust returns ( 5.15% in September, after China's top economic planners gave approved 13 new highway projects on top of their railway initiative). Investors have redeemed a net $4.1 billion since the end of 2008—redeeming just less than $1.6 billion over the last nine months. Year to date through September 30, China funds ( 6.54%) lagged the average return for Lipper's World Equity Funds macro-classification ( 11.46%) by 492 basis points, but for the month of September the China funds classification ( 5.15%) outpaced the World Equity Funds average ( 3.71%).

If investors or their advisors believe there are potential buying opportunities, here are three China funds that have performed very well over the last three years, based on their Lipper Leader ratings for Consistent Return and Total Return. They are the iShares MSCI Hong Kong Index Fund (EWH) with an 8.82 three-year return; the GMO Taiwan Fund (GMOTX) with a 9.28 three-year return and the Templeton China World Fund; and Advisor (TACWX) with a 6.44 return.

The China A-share market recently hitting new four-year lows is one of the factors cited by analysts who advise investors to be wary of the sustainability of the current global equity market rally. And it is certainly the case that the Shanghai Composite Index which has broken below the 2100 level. The same analysts argue for a "catch-up" short trade in Hong Kong-listed Chinese property stocks since A-share property stocks have been falling since early July. This also applies to H-share property stocks relative to the overall Chinese market after their substantial outperformance this year. Historically, there has been a very close correlation between the MSCI China Index and the MSCI China Property Index (0.84 since 2006). But this correlation has collapsed this year to -0.07. So, is this a case of caveat emptor?

Andrew Clark is a manager of alternative investment research at Lipper.
Clark has won several awards for his research, most recently from the
World Congress on Engineering and Computer Science in 2011.