Most of the major cities, including Beijing, Guangzhou and Nanjing, continued to register strong growth, but signs of falling prices spread to other cities such as Baotou and Harbin. This comes after the real estate bubble burst in Wenzhou and in ghost towns, such as Ordos, in the past two years.

Slower real estate growth is in part a result of slower demand during the weeklong Spring Festival holiday. However, unexpected price drops in a few housing complexes in Hangzhou — the capital of coastal Zhejiang province, known for its booming real estate market — beginning in late February stirred up concern about the volatility of property prices.

Prices began falling in Hangzhou, a city of about eight million people, when the developers of two suburban residential complexes started offering discounts. At the  North Sea Park project, prices were discounted from the original listing of 19,000 yuan ($3,100) per square meter to 15,800 yuan. The discount worked — many purchases were made within hours.

Soon after, however, a few smaller cities reported similar discounts. In the nearby city of Changzhou, an important residential complex dropped prices 40 percent. The emerging industrial city of Xiangyang in northern Hubei province reported 10 percent discounts at two housing complexes. Meanwhile, construction on a centrally located residential complex in Xiangyang ended around the same time after the developer went bankrupt.

At the moment, the price cuts are confined to a few complexes and areas associated with specific developers. Nevertheless, falling prices have given way to growing pressure to sell in local property markets across the country, posing a serious threat to the stability of the national real estate market and the economy as a whole.

One catalyst for the widespread price cuts is the state-run banking system’s tighter credit line throughout 2013. Nearly all the developers involved in the cuts are small or midsize firms, which face greater liquidity pressure and higher financing costs than their state-owned counterparts. These problems were compounded by restrictions on residential property since 2011, part of Beijing’s attempt to cool down the real estate market and reduce speculation.

Another fundamental cause of the discounted prices was the growing exposure of the real estate market in many cities. There is massive oversupply and rampant speculation, and local governments are highly dependent on property-related revenues.

Hangzhou is a perfect example. The city was an ideal setting for a real estate boom: It is a critical part of the Yangtze River economic zone, is highly entrepreneurial and  capital-rich and is experiencing rapid urbanization. In the past five years, residential property prices in Hangzhou tripled and in some places even approached prices in Beijing and Shanghai.

The problem is that Hangzhou’s real estate boom was fueled by widespread speculation and the indebted city government’s need to keep prices and construction up.

The real estate sector accounts for about 30 percent of the local economy and 25 percent of Hangzhou’s local budgetary revenue. With a population smaller (8 million vs. 25 million) and poorer (earning about 70 percent of the average income) than Beijing’s, Hangzhou’s real estate market was doomed. By the end of January 2014, the real estate inventory in Hangzhou had reached 120,000, mostly in the suburbs. That is 1.5 times the city’s total sales in the past two years.

What transpired in Hangzhou is a microcosm of the immense challenges to the broader real estate market following years of unprecedented credit-driven investment.

The real estate market has become the linchpin of economic growth and local government financing. The real estate sector boomed behind fast-paced urbanization and skyrocketing demand from the rising middle class, but equally important was the political incentive to offer unrestrained credit in order to turn the market into a driver of economic development. Now that Beijing is focused on the structural problems of the country’s economy and its impending slowdown, the government is no longer able to keep prices high.

Hangzhou’s strong economic fundamentals mean its declining real estate prices will probably be confined to specific districts and complexes. Where the threat is more serious is in small and midsize cities, where debt-fueled housing construction far outpaced demand. Localized restructuring of the real estate market is inevitable in these places. In some ways it is welcomed by the central government, which repeatedly stressed the need to temper soaring costs and squeeze the bubble before it became a bigger problem.

Financial Stresses
Banks began taking precautions as concerns about the volatility of the real estate market grew. China’s Industrial Bank on Feb. 21 confirmed that it had suspended loans to some property developers and tightened financing for real estate-related industries, including steel and cement. With real estate-related financing accounting for a third of the bank’s total assets, the move was widely seen as a preventive measure in anticipation of a declining property market. State media organization Xinhua responded with a high-profile report intended to restore market and public confidence. The report said other major banks had not tightened their real estate-related lending — even though major state banks had already reduced some of their real estate business in early 2012.

A Conversation on China’s Economy
According to official estimates, housing loans by 2013 accounted for about 38 percent of total loans, compared to about 28 percent in 2007. This included 13 percent from mortgages for individuals (down from about 20 percent in 2007), 10 percent for real estate developers and approximately 15 percent for local government financing vehicles (entities created by local governments to raise money for mostly infrastructure and property development projects).

In 2014, approximately 2.39 trillion yuan in local debt will mature, most of which is highly dependent on land transfer fees and thus land and property prices for financing and repayment.

Real estate is the primary source of collateral for about three-fourths of bank loans for many sectors, including manufacturing, steel and shipbuilding. A downturn in real estate prices could undermine the banks’ ability to recover loans.

Bank exposure to the real estate sector is increasingly off the books — in the form of wealth management products, which have become central features of China’s "shadow" lending sector in recent years, or trust funds — since the credit line was tightened in 2011. In 2014 alone, approximately 4 trillion to 4.5 trillion yuan in high-rate trust funds will mature, about 633.5 billion yuan of which is tied to real estate. Sporadic defaults in small and regional banks associated with industries such as coal and steel have already occurred. A sharp decline in property prices would add significantly to the risk of bank defaults.

Beijing still has a handful of policy tools to prevent the real estate crisis from spreading nationwide, including loosening restrictive policies on developers and individuals or adding liquidity to the market as it did during the 2008-09 financial crisis. But the central government is also under pressure to refrain from generating greater systemic risk and putting into question its ability to maintain economic and financial stability.