Harvard professor and former IMF chief economist Kenneth Rogoff was in Hong Kong yesterday warning of disasters looming on the mainland. 'It's a bubble,' he said, describing the mainland property market. And the first signs of a collapse are already visible, which spells bad news to come for the country's banking system. Now the idea that China's property market is dangerously over-inflated is hardly new. Bearish observers have been banging on about a bubble for the past six months or so. But when a heavyweight like Rogoff reiterates the warning, it is worth taking another look at the market in order to reassess the risks. No one doubts that isolated bubbles have indeed developed in Chinese real estate. Prices of luxury properties in big cities such as Beijing and Shanghai clearly overshot reality, propelled by a speculative mania among the mainland's moneyed class. But there are signs that those bubbles are now deflating following government steps to stamp out speculation. As the chart below shows, the value of residential property transactions fell in May compared with the year before. Prices are set to follow. However, despite the dire prognostications of Rogoff and a handful of other China catastrophists, there is no question of a US subprime scale crisis in the making. Relatively few homes in China are bought with mortgages, and those mortgages tend to be small relative to the value of the property. As a result, buyers are well-cushioned against a fall in prices, and so are the mortgage lenders. Developers too should be able to survive even a substantial decline in the market. Although investors have steered clear of developers' debt in recent weeks, according to credit analysts at Barclays Capital, the major property companies have sufficient liquidity to ride out a price drop of 50 per cent in China's biggest cities and 30 per cent in second-tier markets. As a result, whether you believe a fall in mainland property prices is likely to prove disastrous or not depends largely on what you think about the health of local government finances in China. For years, municipal and rural governments have relied on quasi-independent bodies known as local investment companies or LICs to fund their pet development projects. Typically, local governments inject valuable land into LICs, which the LICs then post as collateral against loans from local banks to fund development projects. Last year, the use of LICs really took off, as local governments relied on them as vehicles to finance infrastructure investment as part of Beijing-mandated stimulus efforts. Exactly how much the LICs have borrowed to date is unclear. Estimates vary between 8 trillion yuan (HK$9.19 trillion) and 11 trillion yuan (see the second chart). According to Victor Shih, a professor at Northwestern University in the US, if existing credit lines are fully drawn down, total LIC bank debt could swell to 24 trillion yuan by the end of 2012. The fear is that a steep fall in property prices will severely erode the value of the land that LICs have posted as collateral against their borrowing, possibly triggering loan recalls from the banks. Even worse, a decline in property prices will make it harder for the local governments to raise revenues by selling off state land. With local authorities heavily reliant on land sale revenues to service their debts, widespread delinquencies could follow, leading to a sharp rise in bank non-performing loans and possibly a full-blown banking crisis. Not everyone believes there is a major problem brewing, however. According to Arthur Kroeber at Beijing-based research house Dragonomics, LICs' debt service costs amount to only 14 per cent of recurring local government revenues, excluding land sales. If he is right, overall local governments should have little problem meeting interest payments on their LIC loans. Sure, it is likely some LICs in poorer areas will run into trouble, but Kroeber argues the losses on these loans should be treated as fiscal transfers from China's rich regions to poorer provinces. That is all very well, but it will still leave China's banks facing substantial losses on their loan books. So even if there is no general property bubble and little danger of the economic crisis some fear, a decline in real estate prices is still likely to mean bad news for China's banks, just as Professor Rogoff warned.