The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

By Ka Sing Chan

HONG KONG, July 21 (Reuters Breakingviews) - For one of the world’s most expensive and property-obsessed cities, the mere mention of creating a bad bank for real estate debt is enough to cause a shudder. That’s why the Hong Kong Monetary Authority on Friday was quick to dismiss reports that lenders are mulling such a plan. But it's far from unthinkable.

Sure, systemic risks look limited for now. Bad loans from all sectors of the city's economy stood at $25 billion at the end of March, amounting to just 1.98% of the banking system's total, according to the HKMA’s statistics. And the provision coverage ratio stands at more than 140%. That’s despite a 30% decline in home prices from their 2021 peak.

The valuation of commercial real estate $(CRE.UK)$ has probably fallen more, although the slump has not been fully factored into developers and banks’ books given there have been no notable fire sales. An extended real estate slump would change that.

At the end of March there were some HK$1.4 trillion ($180 billion) of CRE loans in Hong Kong. In a September report, Goldman Sachs analysts argued that a 25% decline in developers' 2023 pre-tax earnings could push the non-performing ratio for that debt up to 22%, surpassing the 1998 Asian financial crisis peak of 17%.

That may sound like an unlikely dire scenario. But six of 11 smaller developers tracked by Jefferies analysts have posted negative EBIT, excluding fair value changes, since 2024, and carry HK$173 billion in debt. One of them, Emperor International 0163.HK, defaulted on HK$16.6 billion of borrowings last month. Add in unlisted property investors and New World Development 0017.HK, which secured a $11 billion refinancing deal in June, and up to 30% of CRE loans in the banking system could be at risk of downgrade, per Jefferies.

New World, whose new loans are due in just three years' time, is in talks to sell a giant airport mall at a 25% loss against its HK$20 billion investment, Bloomberg reported last week, citing people familiar with the matter.

Such disposals will up the pressure on lenders. For instance, the $30 billion Hang Seng Bank 0011.HK - majority-owned by HSBC - has 36% of its book allocated to Hong Kong properties. Its problem loans already stand at 6.12% of its overall portfolio. The lender was one of those involved in a mooted plan to create a bad bank, per Bloomberg. Despite the HKMA's denial, it's likely to become a more frequent topic of discussion.

CONTEXT NEWS

The Hong Kong Monetary Authority has no plans to set up a bad bank to absorb souring debt in the financial system, and it understands that “relevant banks also do not have such a plan”, the de facto central bank said in a statement on July 18.

The rebuttal followed a report earlier the same day by Bloomberg, citing people familiar with the matter, that lenders including Hang Seng Bank recently engaged with advisory firms to discuss setting up a special vehicle to take on their bad debt.

Loans for property development and investment in Hong Kong amounted to HK$1.4 trillion by the end of March, according to the Hong Kong Monetary Authority. Up to 30% of that could be "at risk of downgrade", Jefferies analysts projected in a research note published on February 7.

(Editing by Antony Currie; Production by Aditya Srivastav)

((For previous columns by the author, Reuters customers can click on CHAN/ KaSing.Chan@thomsonreuters.com))