China’s real-estate crisis and local-government debt crisis ―Feasibility of baseline scenario eroded by policy risk―

The real-estate development sector, which has been a driving force for the Chinese economy,is approaching a turning point. The background to this is the fact that both the area and value of property sold have declined for two consecutive years, meaning that the highly-leveraged operations of real-estate development companies are no longer sustainable. The reality is that real-estate developers no longer have any leeway to pursue financial soundness, since they are having to secure funds for debt repayment, as evidenced by an examination of levels of adherence to the “three red lines,” which are financial thresholds that the Chinese government introduced to encourage debt reduction.

Meanwhile, broadly-defined government debt is expected to continue to rise, reaching 147% of GDP in 2027. The pace of debt increase at local-government financing vehicles (LGFVs) is so rapid that government debt is no longer at a “controllable” level. The reason the LGFVs have not defaulted is that the government has asked banks to support them, passing the buck to small and medium-sized banks (SMBs). The International Monetary Fund (IMF) predicts that many SMBs will soon find themselves undercapitalized. Most LGFVs are already “non-viable” and the current LGFV bailouts will eventually fail.

In response to the deteriorating housing market, the government has launched a cash-flow support program to establish bank credit lines for real-estate development companies, and has also come out with measures to boost demand, such as the “equal treatment for second mortgages” principle, which makes it easier for wealthy individuals to own more than one home. However, since a decline in housing-market demand is inevitable, this series of measures can be viewed as a risky policy that could cause greater shocks to the Chinese economy.

The Xi Jinping administration has strengthened the central government’s involvement in the rescue of the LGFVs since the beginning of 2023, such as by issuing “refinancing bonds,” whereby urban investment bonds issued by LGFV(LGFV bonds) are exchanged for local-government bonds, and allowing an increase in the issuance of “Special bonds for SMB,” whereby capital is injected into SMBs. However, these bailout tools are also unsustainable and will likely end up only exacerbating the moral hazards of the LGFVs, local governments, and banks.

The problem with the real-estate crisis is not that more and more real-estate development companies are defaulting, but that none of them are proceeding with bankruptcy or restructuring procedures under the Enterprise Bankruptcy Law, despite the fact that defaults are increasing. And the problem with the local-government debt crisis is not when the LGFVs will default, but that they do not default at all, despite the fact that the number of LGFVs with the potential to default is on the rise.

It is not default risk that is raising concerns about China’s economic outlook, but rather policy risk, as policies seem to lack a clear “end goal.” The downside risks to China’s economy have never been higher, making it increasingly unlikely that the country’s path will follow the baseline IMF scenario of growth slipping to 3.4% in 2028, i.e., a gradual slowdown in economic growth.

PDF link(PDF:642KB)