Brad Setser
The Chinese real estate sector is teetering. The largest private Chinese developer has defaulted on its external bonds. Most developers are struggling to refinance their domestic bonds. Home prices have gone down for the last 11 months. New construction is down 45 percent. The most acute stress can be traced back to developers who raised large sums by preselling yet-to-be built apartments. Some, however, failed to set aside reserves to guarantee the completion of these units, and households that took out mortgages to buy these homes have threatened to stop paying.
China’s real estate crisis poses financial risks, but it is ultimately a crisis of economic growth. Since the development and construction of new property is estimated to drive over a quarter of the country’s current economic activity, it is not difficult to see how a temporary downturn in the property market could become a prolonged economic slump.
The country’s state-backed financial system can still take large losses and thus avoid a financial meltdown. One state-backed institution can put money into another state institution, limiting the chance that losses on lending to a failed property firm will lead to the collapse of its creditors and trigger a cascade of defaults. The Chinese government can ask state-backed developers to complete building projects abandoned by private developers, providing financial help through the state policy banks. Pervasive government intervention isn’t the best way to run an economy over time, but the presence of institutions with deep pockets can prevent the destabilizing withdrawal of all financing to the property market.
As a result, China likely will not suffer a crisis that recalls the U.S. Great Recession of 2008. But that doesn’t mean the Chinese economy is in the clear. A new growth engine won’t automatically replace the boost that the property sector traditionally provided. If China elects to goose growth by increasing exports—as it has done in the past—that could have serious implications for countries around the world struggling to find their economic footing after the shocks of the COVID-19 pandemic and Russia’s invasion of Ukraine.
THE ANT, NOT THE GRASSHOPPER
China’s banks, trusts, and other financial institutions have lent huge sums to China’s property developers, to households looking to buy apartments, and to local governments building public infrastructure even as China’s big policy banks financed construction projects around the world as part of its Belt and Road Initiative. China’s financial system could do both kinds of lending without borrowing large sums from the rest of the world, thanks to the country’s enormously high domestic savings rate, which has averaged about 45 percent of its GDP over the last 20 years. By contrast, most large economies save about 25 percent of their GDP; before the pandemic, the high-saving Asian economies other than China generally saved about 30 percent of their GDP. Only oil-exporting economies generate comparable levels of national savings to China, and they usually do so for only a brief period after a large and unexpected rise in the price of oil.
Saving is often considered a virtue and the absence of significant external debt gives China more options for managing the current property slump. External credit, especially external credit to banks, is often withdrawn quickly during a market downturn. Domestically raised funds, in contrast, are generally stuck inside China.
But too much saving helped create China’s current financial difficulties, as it fostered an economic environment where China’s rapid growth effectively required increasing domestic debt. To understand why, it helps to remember that the counterpart of high savings is low domestic consumption. As a result, China’s rapid growth over the last 20 years has rested on either the ballast of exports or periodic bursts of investment.
Before the 2008 global financial crisis, China’s internal debt-to-GDP ratio was stable, as China could rein in its financial sector while stunning export growth propelled China’s economy and industrial development. Export-led growth minimized debt risks inside China but was destabilizing to the rest of the global economy. It led to job losses in the manufacturing-intensive parts of the European and U.S. economies; the United States was able to overcome the drag on demand from large external deficits only through an increase in household borrowing that proved to be globally destabilizing. Put simply, it was one of the factors that helped spark the 2008 recession.
After the global financial crisis, China maintained its rapid growth while its trade surplus shrank through extraordinary investment in property and infrastructure. Mobilizing such high investment required higher domestic borrowing as well. In the ten years following the global financial crisis, China’s internal debt-to-GDP ratio rose from around 150 percent to well over 250 percent of GDP. In essence, the debts of households, local governments, real estate developers, and state firms have all increased faster than their incomes. Ultimately, that is a risky dynamic.
That said, China’s central government debt has been stable: the country’s debt is less than 20 percent of its GDP—far below that of the world’s other major economies. China’s central state unambiguously has a large role in China’s economy, but that is because it backs most large Chinese banks and many investment funds. The Chinese government doesn’t collect a lot of tax, nor does it spend a lot on social benefits: China has not created a national system of unemployment insurance, does not offer high-quality universal health care, and limits the public services available to Chinese workers who move from rural areas to more prosperous coastal cities.
The result is an unusual mix of financial strengths and weaknesses. The central government in Beijing owns some of China’s most profitable companies, and it backs the healthiest part of China’s financial system, namely the big national banks. It has little direct debt. Local governments, however, are carrying substantial debt and have a weaker revenue base. They are also indirectly responsible for the many state firms created to finance local infrastructure projects, and they back many weaker locally owned banks.
The big property developers, meanwhile, carry staggering debt. The market borrowing of the largest private property developer, Evergrande, is around $100 billion. If all its promised apartments and unpaid bills are counted, the company owes an estimated $300 billion. Its peers have only slightly smaller balance sheets. China’s total debt isn’t a problem for an economy that saves as much as China does—the real problem is that the wrong parts of the economy are carrying most of the debt and will have difficulty repaying.
Still, China will likely manage the immediate financial risk that its property downturn has created. Some of the weaker property developers may not pay all their debt on time and in full. But China’s central government has the capacity to protect important institutions that lent to the big property developers. Beijing can also help local governments that will need to rescue local banks so they can support locally important firms.
China’s central government doesn’t want to cover all losses, however. Too much help would fail to teach a lesson to those who lent to the most poorly managed property developers, potentially leading to a new round of risky behavior. At the same time, the central government cannot allow all the big property developers to fail simultaneously. It also cannot allow losses on past investment projects to stop the flow of new infrastructure financing because China’s economy would seize up from unpaid bills and stalled building projects. Unemployed urban workers and angry buyers of unbuilt apartments would threaten social and political stability. A restructuring of the developers' debts is inevitable—but that restructuring must be combined with steps to help the financial system bear the associated losses and ensure the flow of credit to the economy doesn’t stop completely.
A NEW MODEL
In addition to avoiding a severe financial crisis, the Chinese government also needs to find a new growth engine to replace the ballast the property sector used to provide. Specifically, household consumption needs a jolt. COVID-19 lockdowns have taken a toll, and falling property prices could lead worried households to cut back on spending just when the overall economy needs more consumer demand.
This means China must shift to a new model for delivering stimulus by providing help directly to households. China’s persistently low consumption reflects the insecurities created by limited social benefits, high income inequality, and the burden low-income households carry because of a tax system that raises the bulk of its revenue from consumption taxes and poorly designed payroll taxes. In the long term, China needs a stronger national system of social insurance—in particular, more public health spending and a better unemployment insurance system— financed by higher progressive income taxes collected by the central government.
In the short run, China simply needs to shore up its existing system for providing social services and income support by transferring more revenue to local governments. China has historically kept central government borrowing down by shifting the fiscal burden to local governments. But this approach now risks the country’s financial stability. Local government revenues are under pressure from the property downturn, as they have relied extensively on land sales to property developers to help cover their budgets. The path to a healthier economy—one driven more by household consumption and less by state-guided investment—currently runs through an increase in the central government’s budget.
China, however, has been reluctant to move away from its existing model. The country’s top leadership views direct support for household spending as unproductive, and the finance ministry has consistently resisted running large central government budget deficits. The Chinese government’s recent announcements suggest that it wants to try to restart growth by authorizing more local investment in infrastructure and displacing imports with Chinese technology. But the high-wire act required to keep China’s economy moving without a more stable base of increased domestic consumption will only get more precarious over time.
GLOBAL IMPLICATIONS
China’s trade partners have a large stake in the outcome of the internal Chinese debate. For most of the global economy, the way China grows matters at least as much as how fast it grows. China relied on exports, rather than a rebound in household consumption, to drive its recovery from the outbreak of COVID-19 in Wuhan in 2019. With a shift in global demand toward goods putting upward pressure on prices everywhere, countries around the world have tolerated (if not always warmly welcomed) the increased supply out of China. China’s trade surplus was expected to fall naturally as COVID-19-related disruptions eased globally and in China.
That hasn’t happened. Instead, the latest trade data show that China’s external surplus is rising on the back of weakness in China’s imports. Over the summer, the world economy was lucky, as China’s slowdown reduced commodity demand when the global economy was struggling to adapt to a reduction in the supply. But this doesn’t mean that the global economy can make up for a sustained shortfall in China’s own ability to generate demand for the industrial goods that its economy can now produce in large quantities.
Back in 2009, China’s economy was able to pivot away from exports toward domestic real estate investment to mitigate the global fallout from the U.S. housing crisis because China’s financial system was strong enough to support this shift. Plus, China needed more housing and modern infrastructure. Today, China could not reverse that pivot with a large move away from real estate and back to exports without significant disruption, in part because its share of the global economy has roughly tripled in the years since the global financial crisis. The scale of the lost domestic activity from real estate that would need to be made up through a shift in global demand toward Chinese goods is just too big, and China’s trading partners themselves are often struggling with their own debt challenges.
China can try to manage a permanent downshift in real estate investment by taking steps to sustain and strengthen household demand and by finding new ways to help the industrial sectors that have relied on excessive property investment retool to meet internal consumer demand. Above all, Chinese government officials need to accept this difficult truth: rising internal debt and the end of a period of unusually high investment means that China’s historic growth surge is most likely a thing of the past.
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