China initiated a large-scale leveraging process during the Global Financial Crisis (GFC), with authorities implementing an unprecedented stimulus package that was based on increased lending to several institutions, which included SOEs, property developers and the newly created local government financing vehicles (LGFV). This large stimulus was successful in preventing a recession in China, but it came at the cost of growing financial risks and debt, considering the amount of credit deployed in such a short period, fuelling several asset bubbles in property, stocks and commodity markets. After some initial deleveraging attempts by Beijing (which included policy rate hikes and tighter financial regulation), authorities implemented the famous ‘three red lines’ policy in 2020. This measure, which imposes limits on property developer borrowing, was the critical step that brought China’s growth model, based on real estate expansion, to an end.
Looking at whether China was successful in its deleveraging efforts, we find interesting divergences between different sectors of the economy. Both household and corporate debt have already peaked — the former earlier last year and the latter at the beginning of 2016 — with their leverage ratios having stabilised. On the other hand, the government has not tightened its belt, with debt continuing to increase steadily as a share of GDP. At the aggregate level, debt relative to income continues to grow and therefore, strictly speaking, the Chinese economy has not yet started its deleveraging process. Nevertheless, authorities’ efforts have managed to reduce the pace at which debt has grown in the economy: looking at various measures of credit growth, we can see that on average credit was growing at around 20% during the GFC, by 15% around 2016 and is now less than 10%.
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Chinese efforts to deleverage have had and will continue to have a long-lasting impact on various areas of the real economy, which helps explain the current outlook. The most obvious being the impact on economic growth: where falling house prices have resulted in a negative wealth shock for Chinese consumers, leading to a decline in confidence and constrained private consumption. Meanwhile, the limits imposed on real estate developers credit lines and low confidence, due deterioration in the economic outlook, are acting as a drag on investment demand. This was picked up in a recent survey by the PBoC, with house price increase expectations and willingness to invest both tanking.
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Lower credit supply and demand (due to low confidence) has also resulted in a downward trend for core inflation, not seen since before the pandemic. The only times in which the CPI moved above 3% in recent years was due to swine flu in 2019, which severely affected pork stocks. The property market boom of 2016/17 also generated some upward price pressures, along with the rise in commodity prices in 2021. However, looking at the long-term trend, it now clearly points downwards.
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While the chances of something breaking in the short-term have decreased, there are still risks lurking in the background. A key one that Fathom is monitoring is the possibility of a significant jump in defaults from LGFV bonds. Land sales — the main source of local government revenue — is drying up quickly due to the burst of the real estate boom in China, having fallen by over 57% since its peak in 2021. This creates the risk that local governments might not be able to pay back their loans — many of them directed towards negative-yielding infrastructure projects — which would severely impact local banks and other financial institutions balance sheets, creating risks for the wider financial system as a whole.
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Sooner or later, Beijing will have to act to prevent this risk from gaining traction. In Fathom’s view, the best way to do this would be by reducing local government dependence on land sales as a source of revenue, which could be achieved by establishing a property tax, and/or approving reforms to rebalance central and local government revenue.
The views expressed in this article are the views of the author, not necessarily those of LSEG.
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