China’s Slow-Motion Financial Crisis Is Unfolding as Expected
It is not surprising that China is now facing widespread financial distress, with more to come as the property sector’s woes emerge within the financial system. A credit bubble of historic proportions that drove China’s growth over the past decade is currently unwinding, and slowing the economy as a result. Defaults on multiple asset classes, along with failures at banks and other financial institutions, have raised new questions among depositors and investors about when Beijing will finally intervene more forcefully.
Losing credibility has consequences, as Beijing’s long track record of intervention in response to financial stress has so far been the primary bulwark against crisis. When local government financing vehicles begin defaulting on their bonds, Beijing will need to actively manage the crisis, most likely using the central bank’s balance sheet.
The Credit Cycle Turns
It is difficult to overstate just how disappointing China’s economic performance has been so far in 2022. Even at the start of the year, discussions focused on the potential strength of any recovery, and which sectors might lead that rebound. Instead, lockdowns destroyed that narrative as the economy contracted in Q2 at over a 10 percent annualized rate, posting only 0.4 percent year-on-year real GDP growth. Official growth targets have now been abandoned. Recent data screamed soft credit demand, with private sector companies withholding future investment. New lockdowns in large cities such as Chengdu, as well as national testing requirements before holiday travel, have dampened the economic mood in early autumn. Households have been hit hardest by Covid-19 restrictions and the resulting uncertainty about employment and incomes from service industries, which has slowed consumption. Financial stress is also materializing in multiple places—from protests at banks in Henan to growing boycotts on mortgage payments, as well as accelerating defaults by property developers.
The property sector is predictably at the center of the storm, as the sector represents around 24 percent of China’s GDP, similar proportions of overall employment, and around 30–35 percent of total credit. Viral social media posts in mid-August showed local officials urging their subordinates to buy properties, even if they already owned multiple houses. Property sales revenues have declined by 31.4 percent so far in 2022, leaving developers unable to complete houses that were sold in 2020 and 2021. They are now awaiting financial assistance from Beijing to do so. The property sector was always going to be a drag on growth in 2022, dwarfing any pickup in infrastructure investment, but Covid-19-related restrictions have accelerated and deepened an inevitable economic adjustment.
Yet much of China’s current underperformance—besides the direct impact of Covid-19 restrictions—has been years in the making. The CSIS report Credit and Credibility published October 2018 highlighted the importance of China’s rapid credit expansion in driving China’s growth over the previous decade, and the importance of Beijing’s track record of intervention in the face of financial distress in maintaining stability and avoiding crisis. Starting in late 2016, Beijing launched a deleveraging campaign, acknowledging that credit growth averaging 18.1 percent from 2007 to 2016 was far too fast, and that conditions in the financial system were unsustainable and needed urgent correction. This effort has cut credit growth in half since 2017 by shrinking the shadow banking system, cutting off significant numbers of borrowers and financial institutions. Grasping Shadows, a new project from Rhodium Group and CSIS to be released in early 2023, will more comprehensively assess the impact of China’s deleveraging campaign on China’s economic and financial stability
Beijing delayed a credit growth slowdown because it inexorably would lead to defaults, as borrowers addicted to rolling over loans in lieu of paying off debt with profit would hit the wall. One asset class after another has become unsafe for investment, starting with peer-to-peer lending networks in 2018 and continuing with corporate bonds, local state-owned companies, trust companies, smaller commercial banks, and property developers. In a very short timeframe, China evolved from conditions in which defaults and losses on most financial products were unthinkable (as late as 2017), to a situation in which these losses are increasingly common, across a growing number of asset classes.
With Defaults Rising, Guarantees Are Losing Credibility
The loss of credibility behind Beijing’s implicit guarantees on assets was inevitable, and consequential for the economy. Credit and Credibility argued that China’s long period of financial stability was primarily the result of the credibility built by persistent government intervention to prevent investors, banks, and companies from facing financial losses, rather than conditions such as China’s high savings rate or the internal nature of its debt. The attempt to bail out the boom-and-bust equity market in 2015 was only one step in a series of smaller-scale but similar interventions over the previous decade. At the same time, Beijing had no interest in indefinitely subsidizing increasingly risky financing schemes that had proliferated in the informal banking sector from 2012 to 2016, which were starting to pose systemic risks. As the defaults from these shadow banking loans finally piled up, Beijing started to back away from these implicit guarantees.
Once investors suddenly face losses on an asset they previously considered to be guaranteed, they will similarly begin to question the credibility of the same guarantees in other asset classes considered safe. Ever since the deleveraging campaign started, investors have been disappointed in consistently expecting Beijing to bail them out. Even today, with the property sector’s woes mounting, investors are openly discussing what level of defaults or economic and financial stress will require Beijing to finally step in. But as losses are now plausible for investors in trust products, wealth management products, structured deposits, state-owned enterprises’ corporate bonds, banks themselves, and individual mortgages, there are not many asset classes remaining that carry unassailable promises of government support.
And as the credibility of Beijing’s government guarantees continues eroding, this will impact borrowers’ and investors’ confidence and slow overall credit growth further, weakening investment growth and the broader economy. The fundamental conditions that facilitated China’s rapid economic growth after the global financial crisis have now changed, and risk aversion among both lenders and borrowers is spreading within China’s financial system.
Property Fallout Will Amplify Financial Distress
The fallout in China’s property market is a prime example of this rising risk aversion. Property was the asset that benefited the most from China’s rapid credit expansion over the past decade. Rapid credit growth fed a self-reinforcing cycle of rising property prices, more construction activity, rising land prices and land revenues for local governments, stronger economic growth, and then additional credit growth to the sector and even higher property and land prices. Property was the asset bubble that did not pop for two decades precisely because there was a widespread expectation that local governments depended upon the market and rising land prices, so they could never allow it to fail.
But ultimately, the rise and fall of China’s property market were tied to changes in credit conditions. Chinese authorities tried but failed to control the property sector’s rise amid rapid credit growth, and they will have limited success containing its fall as the sector faces a sharp credit crunch. The only surprise has been why the credit-dependent sector continued expanding rapidly from 2017 to 2020, even after the shadow banking system contracted.
Property developers bought themselves a few more years of growth starting in 2017 by substituting informal credit from the shadow banking system with credit directly from homebuyers, in the form of pre-construction housing sales. Developers are currently facing a collapse in property sales, and the drop is too large to be fully offset through fiscal policy or credit policy. Developers’ total annual residential housing sales revenues reached a peak of 18.0 trillion yuan ($2.7 trillion) in June 2021, but have now declined to only 13.2 trillion yuan over the past 12 months, a loss of 4.8 trillion yuan, or around 4.5 percent of GDP. The credit crunch is currently extending, with more homebuyers threatening to halt payments on their mortgages, leaving even fewer interested in buying homes before they are fully built. Sales of completed houses this year are actually unchanged—only sales of pre-construction houses are declining.
As argued in Credit and Credibility, the Chinese system is most vulnerable to crisis during attempts at reform, such as Beijing’s attempt to rein in the property sector, not from exogenous shocks like the Covid-19 pandemic. China does not want to continue relying upon the housing sector to drive economic growth—most technocrats in Beijing have been concerned about the property bubble for years, and do not want to see it grow even larger. As a result, no one can be certain how much financial stress Beijing is willing to tolerate before finally backstopping the market. And that uncertainty allows financial contagion from losses in the sector to continue spreading.
Local Government Financing Vehicle Bond Defaults Are Next
Nowhere is the stress from the property sector more apparent than local government finances. Localities have been impacted by the decline in land sales to struggling developers, with those sales down 48 percent by area and 32 percent in terms of revenues so far this year, according to Ministry of Finance data. Local government financing vehicles (LGFVs) were some of the primary borrowers from the shadow banking system, and many localities have already suffered from the deleveraging campaign and its impact on informal financing. The pain has been spread unevenly across Chinese provinces as well, with credit contractions hitting hardest in northeastern and western provinces.
Local government state-owned enterprises have already occasionally defaulted on their corporate bonds, and investors have started to assess credit risks of many corporate bonds based on the fiscal conditions of localities themselves. However, the one Rubicon that has not yet been crossed is a default on an onshore local government financing vehicle (LGFV) bond. These are still considered to be implicitly guaranteed by most investors, and have actually been bid aggressively in recent months, because there are few other “safe” assets in China’s bond market still offering reasonable yields. Yet given local governments’ financial distress and declining land sales revenues, a bond default by LGFVs is only a matter of time. The period immediately following the 20th Party Congress this autumn may be particularly dangerous, given that newly appointed local officials will likely wait out the political season over the next two months before trying to extricate themselves from their predecessors’ debt starting in November.
When the credibility of guarantees on LGFV bonds evaporates, almost half of China’s corporate bond market will suddenly face new credit risks. Refinancing for these firms will be extremely difficult, as the average duration of their bonds has declined from 5.5 years in 2016 to only 3.3 years in 2022. If LGFVs are unable to refinance their debts, most of the mechanisms for implementing Beijing’s fiscal policy will become basically inoperable, because these are the entities that actually build local infrastructure projects. A bailout of LGFV debt and other forms of local government debt will become a necessity, very quickly.
Where Are the Technocrats?
As China’s credit growth continues to slow, the consequences are reasonably predictable. Overall interest rates are likely to decline as Beijing will need to keep rates low to manage debt levels. Expanding the central bank balance sheet is the most obvious tool to absorb some of the pressure of rising defaults, which will likely catalyze capital outflows and additional depreciation pressure on China’s currency.
Technocrats always appear far more capable during credit expansions and far less prepared as credit bubbles unwind. Many investors are now asking why China’s economic technocrats appear so restrained in responding to widespread economic and financial distress. The choice now facing Beijing is where to try to redraw a line in the sand to defend the credibility of government guarantees on certain types of assets, presumably including central state-owned enterprises and state banks. But until Beijing makes that choice, defaults will continue and will expand to new asset classes while credibility erodes. Widespread failures of LGFV bonds would force Beijing’s hand, and some sort of bailout, fiscalization, or monetization of local government debt would likely be necessary to restore these local vehicles to their regular operations.
Once Beijing starts down the path of expanding the central bank balance sheet to manage domestic financial stress, China will appear to the rest of the world to be engaged in crisis management rather than regular monetary or counter-cyclical policy. When the Covid-19 pandemic started, China’s central bank argued publicly that it was acting responsibly by refusing to conduct unconventional monetary policy in response to the economic fallout. New local government bailouts would mark an abrupt about-face in that position, but in the face of a serious liquidity squeeze for China’s localities, no other option would appear feasible.
The slow-motion financial crisis now unfolding in China is exactly what should be expected as a historically large credit bubble unwinds. Some still argue the deleveraging campaign was a success and reflected the adaptability of China’s system and the wisdom of Beijing’s technocrats in containing systemic risks. It is reasonable to argue that continued rapid growth of the shadow banking system would have been far worse, and could have sparked a crisis earlier. But overall, the deleveraging campaign replaced one form of financial risk with another, and one can see the widening and predictable consequences of slowing credit growth and Beijing’s weakening credibility.