China’s real-estate market is a “particular source of risk” to growth given the importance of property construction to the world’s second-biggest economy, the World Bank said today.

“Shocks to the property sector that would slow down construction significantly could have a large impact on the economy and on bank balance sheets,” the Washington-based lender said in its China Quarterly Update released in Beijing. “A property downturn could affect the finances of local governments, which do a lot of the infrastructure investment.”

Regulators told China’s banks last week to conduct more stress tests on their real-estate lending as the government steps up efforts to curb surging housing prices. A potential rise in bad debts on property loans and credit to local government financing vehicles risks triggering another state- funded bailout, Fitch Ratings said this month.

“With tension between the underlying upward housing price pressure and the policy objective to contain price rises, interaction between the market and policy measures could lead to a more abrupt than planned downturn in the real-estate market,” the World Bank said in its report. High property prices should be controlled through “macroeconomic levers” rather than administrative measures, the bank said.

Premier Wen Jiabao last month ordered local governments to cap gains in new-home prices after curbs on mortgage lending, higher down payments and limits on purchases failed to stem increases. The government is studying rules to control developers’ profits to keep prices at a reasonable level, the China News Service reported yesterday.
Affordable Housing

Property companies including Poly Real Estate Group Co., the nation’s second-largest developer by market value, declined in Shanghai trading today amid the fifth straight daily drop in the benchmark index on speculation the government will increase interest rates. The Shanghai Composite Index fell 0.2 percent to 2,919.98 at 1:14 p.m.

The yuan rose to the strongest level in 17 years, touching 6.5015 per dollar in Shanghai today, according to the China Foreign Exchange Trade System.

Growth in the prices of new homes slowed in Beijing and Shanghai in March, a statistics bureau report showed last week, as the government intensified property curbs. Of the 70 cities monitored in the survey, 67 posted gains, down from 68 in the first two months, the report showed.
Affordable Homes

Wen has vowed to boost construction of social housing to make homes more affordable to low-income families, setting a target to build 36 million units over the next five years.

Still, the success of the policy will depend on issues such as costs and financing, the World Bank said in its report.

Of the 1.4 trillion yuan ($215 billion) investment needed this year, 800 billion yuan will come from purchasers or companies involved in renovation, and around 100 billion yuan from the central government, according to the report. The rest will need to be generated by local governments through channels including land revenues and bank lending.

“The large scale and time pressure, and already stretched finances of some local governments, suggests the execution may not be straightforward,” according to the report. “The exact structuring of the financing will be hugely important for sustainability and efficiency.”

The World Bank raised its inflation forecast for China this year to 5 percent from a 4.7 percent estimate last month, compared with the government’s target of 4 percent.
Price Curbs

Policy makers have stepped up efforts to curb price gains that have exceeded official targets for the past nine months. In addition to raising interest rates and banks’ reserve requirements, the government has limited increases in domestic fuel costs, told companies including Unilever and instant-noodle maker Tingyi (Cayman Islands) Holding Corp. to refrain from raising prices and cut road toll charges for food transport.

China needs to use economic policies rather than moral suasion and administrative orders to rein in inflation as the latter “could create distortions and are unlikely to be effective for a long time,” the World Bank said. Concerns about inflation shouldn’t delay changes in resources and utilities costs that would help transform the nation’s growth pattern, it said.

Gains in food prices, which have driven the acceleration in inflation over the past year, are slowing although much of the impact of higher oil and industrial commodity costs is still in the pipeline, according to the report. Economic growth, wage increases, higher energy costs and the lack of land mean food prices will likely continue to increase at a faster pace than manufactured goods over the medium term, it said.
Credit Growth

While it is too early to stop tightening policies, if a slowdown in growth “materializes and inflation eases, the case for further monetary tightening weakens,” the World Bank said.

Monetary policy could be more effective if interest rates were allowed to play a larger role, the bank said. The proliferation of credit other than bank lending “makes it increasingly difficult to lower credit growth using quantitative guidance” to commercial banks, according to the report.

China grew 10.3 percent last year as it rebounded from the global financial crisis, overtaking Japan as the world’s second- largest economy.

The World Bank estimates the economy will expand 9.3 percent this year, higher than its 9 percent forecast published on March 21, because of a stronger-than-expected gain in the first quarter. Slower global growth, inflation and the impact of the government’s tightening policies on investment, will ease growth for the full year, according to today’s report.

The lender increased its estimate for expansion next year to 8.7 percent from 8.5 percent.