Worried about macro-financial risks, Chinese economic policymakers have been seeking to rein in unsustainable investment in infrastructure and the real estate sector, but such an approach tackles primarily the symptoms rather than the underlying cause, as a sustainable solution to the so-called excess savings problem requires broad reform aimed at reducing savings or creating more profitable investment opportunities. The underlying cause of increased financial risks appears to be a very high savings rate in the context of a declining profitability of investment. At the very least, it is the structure of Chinese investment, concentrated in infrastructure and housing, that is generating declining and increasingly negative financial returns. A declining profitability of investment is to be expected as China approaches the technological frontier and the marginal productivity of capital declines and highly profitable investment projects become scarcer. The recurring misallocation of capital or overinvestment forces policymakers to rein in investment, most notably investment by local governments in infrastructure and, more recently, by real estate developers in housing. These policies aim to limit economically unproductive and financially loss-making investments that do support sustainable growth and increase financial instability risks. This is very challenging given the financial interrelationship between housing, banks, local governments and the central government and given the high levels of debt that have hitherto accumulated.
> Real estate sector related activities account are estimated to account for 30% of GDP. This much higher than in advanced economies, where the equivalent ratio is 10-20% of GDP. Shifting around 10% of GDP from one sector to another or others necessarily creates a significant economic drag if it is done precipitously and not strongly supported by massive, flanking macroeconomic measures.
> Total social financing, or total debt outstanding, particularly for an emerging economy, if less so for an economy with a high savings rate. Debt has doubled in the past 15 years, increasing from 150% of GDP in 2009 to 300% of GDP today. This extraordinarily rapid increase and high levels of debt raises concerns about creditworthiness and financial stability risk. Declining economic growth and low inflation, alone deflation risk being exacerbating credit and financial risks because they make it harder to service the debt.
> China’s economic growth has decelerated from more than 10% in 2009 to around 5% in 2023. The IMF projects a further deceleration to less than 4% in the next few years. The incremental capital-output ratio, which measures the amount of capital required to generate one unit of economic output, has halved. This suggests that the efficiency of investment has declined dramatically. Investment is too high, or investment opportunities are too limited.
To avoid the so-called middle income trap, Chinese policymakers have been facing a difficult balancing act in terms of shifting investment and the economy away from unsustainable infrastructure and real estate sector investment while limiting macro-financial risks and sustaining robust economic growth. China appears to be facing the so-called middle income trap where the old high-growth model becomes unviable as a country approaches middle-income levels and a sudden, substantial downward shift in economic growth takes places, often in the context of a broader economic or financial crisis. The middle income trap is a frequently observer empirical reality, but not a theoretical inevitability, provided policymakers pursue a forward-looking policy aimed at reforming the economic growth model and managing macro-economic and macro-financial risks properly. A policy aimed at structural, productivity-growth-enhancing reform allows for more profitable investment opportunities and a more economically productive allocation of China’s large savings. If flanked by prudent financial policies aimed at maintaining financial stability, such as ensuring adequate bank capitalization and other prudential policies as well as by supportive macroeconomic policies to limit the negative economic effects of macro rebalancing, macro-financial and macro-economic risks will be manageable.
Despite significant policy efforts, China has made little progress in reducing excess savings and rebalancing the economy towards more sustainable medium-term growth. As far back as 2008, then-President Hu Jintao called for economic rebalancing. The initial impetus for rebalancing and reform was China’s dependence on exports and export-sector focused investment against the backdrop of the global financial crisis in 2008, which showed how vulnerable China’s export-oriented growth models was in the face of large external shocks. At its height, China’s current account surplus exceeded 10% of GDP, which also lead to trade tensions, particularly with the United States. After implementing a massive infrastructure investment program as a response to the global financial crisis, policymakers’ efforts were forced to focus on controlling the build-up of macro-financial risks related to massive infrastructure investment. The sharp investment-related increase in debt, particularly among local government, led policymakers rein in local and provincial level infrastructure investment through a stricter enforcement of local borrowing, including off-balance sheet structures like local government financing vehicles (LGFV). In 2020, efforts have focused on tackling over-investment in the real estate sectors. Thanks to policies aimed at reining in excessive investment, China has managed to avoid broader financial instability but it has thus far failed to bring about macroeconomic rebalancing. Savings are lower than 15 years ago, but investment has remained virtually unchanged.
> In August 2020, China introduced the so-called “three red lines” policy, which imposed ceilings on debt-to-cash, debt-to-assets and debt-to-equity ratio for real estate developers. The policy was meant to reduce excessive debt of real estate developers and, indirectly, rein in excessive investment in the sector by forcing financially to exit. This has led to significant financial distress among developers and a sharp real estate downturn.
> China’s national savings rate fell from more than 50% of GDP in 2009 to 45% of GDP in 2023. But the savings ratio is same as in 2016. At 42% of GDP, the savings rate is virtually unchanged compared to 2009. The difference is accounted for by far smaller current and trade surpluses.
While economic rebalancing has led to a cyclical deceleration of economic growth, policymakers have thus far taken only modest countercyclical macroeconomic measures. The rationale appears to be that the housing market will not shrink forever and significant macroeconomic measures might undermine rebalancing. Policymakers have several options to provide short-term countercyclical support to limit the economic downturn (and the risk of deflation) They can pursue a more expansionary fiscal policy aimed at spurring consumption, a more expansionary monetary policy aimed (primarily) at increasing investment or measures aimed at allowing for a weaker exchange rate to boost exports. Such policies would help counter the cyclical drag from the real estate sector adjustment and, at the margin, reduce savings by increasing consumption and especially household consumptions. China has refrained from resorting to quasi-fiscal and investment-fueled spending comparable to the post-global financial crisis, as this would exacerbate imbalances due to infrastructure-focused growth and as they seem to expect the economy to recover on its own. But the option remains on the table. However, structurally, underlying housing demand will decline sharply 35-50% due to demographic change. This raises the question where savings will go if they are not converted into housing. A possible solution consists of lowering the savings rate by increasing domestic and especially household consumption through broader fiscal reform aimed at raising household incomes, such as providing social security or health care benefits. Another solution consists of implementing productivity-enhancing economic reform that allows for a financially productive conversion of savings into investment, such as pro-market reform.
> Underlying housing demand will decline sharply 35-50% due to demographic change, slowing urbanization and changes in household formation, according to the IMF.
> The PBoC has been cautious with respect to loosening monetary and financial conditions over the past couple of years. The government has refrained from administering a large-scale fiscal stimulus. Instead, the central government has provided limited fiscal support to cash-strapped local governments to counteract the fiscal drag from lower spending. Local government’s reliance on land sales and other real estate sector related activities reduced the amount of money available to support local government spending. The central government is in a position to provide greater support, should it choose to do so, despite relatively high public sector debt.
Despite the growth slowdown and financial stress, macro-financial risks will remain manageable due to the government’s ample ability to intervene in case financial distress threatens to turn systemic. Systemically important national banks’ loans to both real estate developers and mortgages appear manageable. Smaller, regional banks as well as non-bank financial institutions are at greater risk. The slowdown in real estate sector activity is also affecting local government finances, spending and economic growth. Should financial losses accumulate, the central government has a strong enough financial balance and sufficient scope for intervention to preempt local financial distress from turning into a systemic financial crisis. It can also exercise regulatory forbearance. In case of a run on a bank, it can simple take over the bank, write down equity holders and junior creditors, while guaranteeing deposits. Not only are the central government and the central bank able to absorb the losses, if necessary, but they have also wide-ranging discretion about how to distribute financial losses across different creditor classes. The same rationale applies to a large, systemically important banks that already benefit from implicit government backing.
The government can and will backstop systemically important financial institutions should they run into financial trouble. If these smaller banks get into trouble, the authorities will step in if they pose broader risks to financial sector stability through recapitalization, forced mergers or an orderly resolution. In case of systemic crisis risk, the authorities can simply bailout the banks creditor, bail out part of the banks’ creditors (like retail depositors). The government or government-owned Chinese banks can help backstop through liquidity guarantees, takeover or financial support and recap and more sustainable model by not reward moral hazard to force private sector to internalize economic and financial risks (losses borne by risk-takers), improving the efficiency of capital allocation and reducing financial and macro-financial risks. Similarly, the bailout and restructuring of local government debt simply leads to a reshuffling of national balance sheet/ assets and liabilities between central government, local, banks, investors households. Ultimately, it is the authorities’ ability to provide financial support and largely determine to what extent to bail out or bail in creditors that allow the government to intervene should destabilizing financial distress emerge. Capital controls and a net international creditor position make it impossible and unnecessary for depositors to move money out of China, further enhancing the government’s ability to deal with macro-financial risks.
> At more than 100% of GDP, government debt, and especially so-called augmented government, which includes local government’s off-balance sheet liabilities is high. But gross debt does not account for the extensive assets, the public sector holds. The IMF estimates the public sector’s net financial worth may not be negative. Virtually all debt is owed to residents. Capital control prevent destabilizing capital flights.
> China’s international balance sheet is solid. Large foreign-exchange reserves, exceeding $3 trillion, and capital controls and net foreign creditor position make a balance-of-payments or external debt crisis impossible. China's banking sector’s net external assets amounted to $169.6 billion, including net RMB liabilities of $287.3 billion and net foreign currency assets of $456.8 billion. This suggests that the banking sector would benefit from a weaker currency, all other things equal.
> A further deterioration of local government’s financial position and financial viability of LGFVs will sooner or later require a central government bailout or a debt restructuring, including write-downs and assets sales. This will help limit creditor losses, including banks. Government guarantees and regulatory forbearance as well as an ability to provide a government guarantee if necessary sharply curtail the risk of a systemic financial crisis due to local government debt problems. About two thirds of the total LGFV debt is in the form of bank loans. The IMF estimates that 1/3 LGFVs are financially nonviable.
> The bank sector as a whole is characterized by low levels of non-performing loans and overall fair capital adequacy ratios. More importantly, property sector and mortgage loans represent a much smaller share of assets among large banks than smaller banks as well as various non-bank financial institutions.
While the risk of destabilizing, systemic financial crisis is low, the risk of a further economic slowdown in the context of insufficient demand and continued, relatively unproductive over-investment will be substantial, unless policymakers implement productivity-enhancing, market-oriented economic reform. However, it is highly uncertain that policymakers will implement necessary productivity-enhancing reform. In 2013, the government committed to let the market play a “decisive” role more than a decade ago. But the government has made little progress towards greater market-oriented liberalization. The government and SOEs are playing a greater role in capital allocation and government officials play a more important on corporate boards. Private-sector investment remains low, while public-sector investment has increases in the past few years. Greater government intervention is taking placing against the backdrop of intensifying geopolitical competition, international economic fragmentation, technological decoupling as well as adverse demographics. Nevertheless, China has opted for less risky and more sustainable growth, even if it means lower growth. Economic growth is unlikely to exceed 5% unless the government shifts towards a greater market-based allocation of savings flanked by growth-enhancing structural reform and a fiscal policy geared towards reducing the national savings by increasing household incomes and private consumption.