Deflating House Prices And A Deflating Economy
The second-largest global economy, China, currently faces a deflating property bubble, local governments struggling with debt payments, and a banking system exposed to these issues. In many other countries, these factors would typically signal a looming financial crisis. However, the conventional belief is that China's unique circumstances make this unlikely. The rationale is that most of China's debt is domestic, the government supports a significant portion of the financial system, and competent technocrats are managing the situation.
- Nevertheless, it might be perilous to rely solely on conventional wisdom. Although an immediate meltdown on the scale of the 2008 global financial crisis, triggered by Lehman Brothers' collapse, is improbable, China's fiscal and financial imbalances are so significant that it has entered uncharted territory.
- It is unclear how effectively the Chinese economy, especially with President Xi Jinping's concentrated leadership, can navigate these challenges.
Slow Growth And Higher Deficits
The magnitude of the problem becomes evident from recent reports by the International Monetary Fund (IMF). First, despite China reporting better-than-expected economic growth of 4.9% in the year up to the third quarter, its medium-term outlook has deteriorated. The IMF now projects China's growth to average only 4% over the next four years, down from the previous projection of 4.6% a year ago. This makes it much harder to grow out of debt compared to a decade ago when growth was at 10%.
- Second, the IMF has raised its estimates for Chinese government deficits, expecting them to increase from 7.1% of GDP this year to 7.8% in 2028, placing China alongside the U.S. in terms of fiscal challenges.
- The core issue lies with local governments that borrowed heavily through off-balance-sheet financing for urban development projects. Their liabilities now account for 45% of GDP, and if included in China's government debt, this figure would rise to 149% of GDP by 2027, surpassing Italy's debt level at 141%.
Local Chinese governments are struggling to service their debts due to declining land sales, a primary revenue source. The IMF estimates that 30% of local government financing vehicles are "non-viable without government support". This poses a substantial challenge for Chinese banks, which hold approximately 80% of this debt. Even a partial restructuring of this debt could lead to impairment charges of $465 billion for these banks, significantly impacting their capital ratios.
- Chinese banks are not as well-capitalized as their global counterparts. In a recession, their capital could deplete further, as indicated by IMF stress tests. In a simulated adverse scenario, Chinese banks' capital ratios would drop from 11% in the previous year to 7.1% in 2025, the worst outcome compared to other regions under the stress tests.
- There is also the potential for feedback loops in this situation. As loan losses increase, banks may reduce lending. Unable to borrow, local governments may cut back on investments and social services, further weakening economic growth and property values.
While foreign capital flight significantly amplified financial crises in Latin America, Southeast Asia, and the Eurozone, China is a net lender to the world and tightly controls capital flows. Chinese banks are primarily owned or controlled by the government, reducing the likelihood of bank runs and panics. However, financial crises can still occur when local, rather than foreign, investors lose confidence. The ambiguity of implicit, rather than explicit, guarantees can be destabilizing.
...With Global Impact
The risk of a financial crisis in China could emerge when investors realize that the government may not fully back their assets. For instance, the perception of Beijing's changing priorities led to credit risks in the property sector, as more developers' finances were scrutinized. As the government's implicit support is withdrawn from peripheral assets, investors may start doubting its application to core assets, such as small banks, mortgage loans, and local governments, potentially leading to a crisis.
- Chinese officials are aware of these risks and have taken initial steps to restructure local government debts and encourage troubled developers to complete projects.
- However, the scale of the debt and slow growth makes it challenging for China to address bad loans as it did two decades ago.
- Concerns also exist regarding the quality of governance under President Xi.
The implications for the rest of the world are significant. A multiyear financial crisis in China, which erodes consumer confidence, could reduce import demand while increasing exports, impacting foreign producers. While the potential for contagion is limited due to China's relative financial isolation, the sheer size of its financial system means that any turmoil is likely to have ripple effects felt globally.
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