Why China Still Faces a ‘Hard Landing’: Nomura
China's economy, which has shown signs of stabilization recently, still faces a number of major risks and there is a one-in-three chance of a sharp slowdown in growth or hard landing before the end of 2014, says the brokerage Nomura.
A pick up in Chinese economic data has raised hopes that the worst may finally be over for the world's second largest economy, which has slowed for seven straight quarters.
But the risks facing China's economy have been building, according to the Nomura China Stress Index of 18 leading indicators that include real estate investment, banks' reserve requirement ratio, inflation and the number of nationwide labor disputes.
These risks raised the index to 101.6 in the third quarter, from 101.5 in the second quarter, reinforcing Nomura's view of a one-in-three chance of a hard landing for the Chinese economy.
Nomura defines a hard landing as average growth of 5 percent year-on-year or less over four consecutive quarters.
China's economy expanded by 7.4 percent in the third quarter, slowing from 7.6 percent and 8.1 percent in the previous two quarters.
Leading the uptick in the stress index was shadow banking activity, which Nomura's chief Asia economist Rob Subbaraman calls the "most worrisome gauge".
Shadow banking refers to the financing that's outside the official banking system and which is provided by hedge funds, money market funds, trusts and corporate bonds. This funding goes into property development or infrastructure projects that have had trouble tapping normal loan channels because of credit curbs aimed at curbing speculative investment.
The level of shadow banking activities climbed to 46 percent of total social financing in the third quarter from 34.7 percent in the second quarter, Nomura said. And according to the People's Bank of China, total social financing rose significantly in September to 1.65 trillion yuan ($264.2 billion), from 1.24 trillion yuan in August.
"This is I think the most worrisome gauge because the sector is not strongly regulated at all. There is a big risk of financing going to borrowers who are not as credit-worthy as lenders perceived to be," Subbaraman said. "If there's a bust, it could have serious repercussions for the economy."
And this means that the China Stress Index could go higher if the growth in shadow banking continues unabated, Nomura said.
The growth of shadow banking in China has led to warnings from the International Monetary Fund and a senior official from the Bank of China, China's third largest bank by assets. Both have said that there is a real risk that non-performing loans are higher than official data suggest.
Official numbers show that Chinese banks' non-performing loans were at a low 0.9 percent at the end of the third quarter, compared to about 5 percent for U.S. banks, according to data from the World Bank.
(Read More: Bank of China Executive Warns of Shadow Banking Risks)
Other risk indicators such as real estate investment as a percentage of GDP, banks' reserve requirement ratios, property loans as a percentage of banks' loan books, inflation and the number of labor disputes have all seen an uptick over the third quarter, Nomura said.
Real estate investment, for example, still made up 13.7 percent of China's economy in the third quarter, unchanged from the second despite administrative measures to rein in speculative demand. This is also up from about 13 percent for the full-year 2011.
Property loans on banks' loan books also ballooned in the third quarter, as Chinese banks lent 416.8 billion yuan ($66.65 billion) to home buyers and property developers, up 29 percent from the previous three months. Property loans accounted for 15.4 percent of total new loans issued in the first three quarters, up from 12.3 percent from the previous period.
This does not bode well for the rebalancing of the economy that the Chinese government has been seeking, that is, GDP growth that's driven less by investment and more by domestic consumption.
(Read More: Changing China Special Report)
"We do worry about the quality of the growth," Subbaraman said. "We still think there's going to be a cyclical upswing in the fourth quarter and the following quarter but we do think that risks are building and could go further up."
—By CNBC's Jean Chua