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By Sean Geary

Chinese stocks (NYSEARCA:FXI) endured a massive drop in Monday trading with the Shanghai Composite falling 3.6% on the back of concerns pertaining to the domestic housing market.

Worried over a potential housing bubble, the Chinese government finally implemented long-rumored measures designed to curb housing prices. Beijing enacted new property taxes as well as other disincentives in an attempt to cool down the red-hot sector.

While speculation has existed for months that the government would put such measures into place, Chinese stocks had evidently not priced in these measures. The announcement saw the property sector head substantially lower, with some equities with exposure to the sector dropping more than 7 percent.

Real estate stocks were not helped by an interview on 60 Minutes with the head of China Vanke, a developer, during which the chairman expressed his opinion that China was indeed in the middle of a housing bubble.

Although many refer to the Chinese housing market in its current state as a bubble, in order to accurately grasp the sector, one must not treat it as a monolithic entity. Essentially, the Chinese housing market is bifurcated; prices are slipping in third and fourth-tier cities as oversupply has become a problem, while apartments in first-tier cities remain in high demand. A recent increase in rental prices may indicate that these housing prices may be justified on a price-to-rents ratio. As illustrated by the Economist, Chinese housing prices appear far healthier than those of Canada, Hong Kong, Singapore, and Australia. As well, although prices remain elevated based on average Chinese income, because of substantial wealth inequality and significant high-end demand, these metrics may not necessarily indicate a housing bubble in first-tier cities.

Even though housing in first-tier cities appears to be in fine shape, a collapse of third and fourth-tier real estate could be problematic for Chinese stocks in the sector; highly-leveraged developers, in particular those with disproportionate exposure to inland cities, could be in trouble. As well, banks with large real estate loan portfolios could also be adversely affected.

In terms of Chinese equity markets as a whole, today’s developer-lead drop saw the Shanghai Composite break through technical support at the 50-day moving average. If today’s market action is any indication, the fantastic run in Chinese stocks from December to February could be over.

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Source: Chinese Stocks Suffer Biggest 1-Day Drop Since 2011