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China's shadow banking firms slashed lending to property developers in the first half of this year, closing off a crucial funding avenue just as the housing market cools, potentially spelling trouble for the sector and the broader economy.
Trust companies, which pool money from rich people and companies to make high-interest loans and are part of the China's vast and opaque shadow banking system, were a ready source of cash during the housing boom, particularly for smaller developers that had trouble borrowing from banks.
But in the first half of this year, trusts lent real estate firms 39 percent less than in the previous six months, according to trust research company Use Trust based in Nanchang. At the same time, the average interest on 48.3 billion yuan ($7.78 billion) in loans made through wealth management products climbed 16 basis points to 9.67 percent.
That bodes ill for Chinese developers who must repay nearly 600 billion yuan ($96.83 billion) worth of trust loans next year, according to brokerage firm Jefferies.
"Default risk is heightening because trusts rely heavily on house prices rising," said Xie Ya Xuan, an economist at China Merchants Securities' Research and Development Center in Shenzhen.
Trust firms, under greater scrutiny from regulators worried about rapid growth of shadow banking, are both finding it harder to raise money themselves and growing wary of lending to developers, particularly smaller ones, while the market cools.
New home prices in China fell in June for the third straight month, private sector surveys show, as some developers cut prices to spur sales, with many expected to offer steeper cuts as they scramble to meet 2014 sales targets.
That could squeeze developers with trust loans coming due in the next 12 to 18 months as a supply glut clouds the outlook for the property sector.
With its 15 percent share of China's economy and direct impact on 40 other sectors, many economists identify a property market downturn as the main risk to Beijing's 7.5 percent growth target for this year.
Tightening credit conditions make it tougher for developers to refinance and roll over their trust loans.
Total funding for real estate developers this year added up to 4.7 trillion yuan at the end of May, up 3.6 percent from a year earlier, according to the National Bureau of Statistics. It marks a significant slowdown from a 32 percent growth in the same period of 2013.
"If the trust loan can't be rolled over, then the company will be in trouble," said an executive at a Hong Kong-listed developer who declined to be named.
While trusts are cutting their exposure to small developers, they appear to be ramping up loans to bigger companies.
Evergrande Real Estate Group, ranked as China's third largest developer by sales in the first six months, raised 3.3 billion yuan by July 7 via trust loan products for its projects this year, according to Use Trust.
Evergrande declined to comment.
Trust companies said they have become more selective over real-estate related refinancing projects and they prefer infrastructure investments over property as they are usually backed by governments.
"We basically don't do developers smaller than provincial level or small to mid developers anymore," said a trust manager at Minmetals International Trust, who declined to be named as he was not authorized to speak to the media.
Bigger is not necessarily safer. Because these project loans are classified as equity rather than debt, they can make a company's balance sheet look healthier than it is. Barclays pointed out in June that Evergrande's total debt-to-equity ratio would be a steep 220 percent if all its funding sources were counted as debt.
"We believe the company is over-leveraged, especially with regards to its perpetual securities products, and this may bring in a painful punch should sales continue to slow," Barclays analyst Alvin Wong wrote in a note to clients.
Read MoreInvesting in China: A Catch-22?
Trust loans came into the spotlight this year after several delayed payments and defaults.
Last month, China Ting Group Holdings said it was unable to receive two interest payments for its HK$200 million ($25.81 million) entrusted loans to Hangzhou-based developer Zhongdou Group, who was reportedly in 2 billion yuan debt. A Jiangsu shipbuilder also said in April a 105 million yuan entrusted loan to a Nanjing developer was defaulted.