The Chinese economy is hurting. Officially, the Chinese gross domestic product (GDP) registered a robust 5.5 percent growth in the first half of 2023. Unofficially, the picture appears much bleaker. However, a simple economic slowdown would be manageable for the Chinese Communist Party (CCP)—but it’s the financial risks that worry the regime.
Following the 2008 global financial crisis, the Chinese regime fueled economic growth with heady doses of capital infusions financed through debt. Provincial leaders took out debt to finance infrastructure spending. Households borrowed more to buy more homes. Corporate leaders borrowed from banks to finance ever-ambitious growth plans.
According to the International Monetary Fund, in 2008, general government debt to GDP stood at a tiny 27 percent. Still, by 2022, that number had grown to 72 percent and didn’t include large amounts of unofficial government debt tied to local government financing vehicles. By multiple accounts, China’s debt now exceeds 300 percent of GDP. Chinese households became some of the most indebted in the world relative to income.
With the real estate urbanization boom slowing rapidly, this is placing enormous pressure on everyone. Local governments, who would get, in some cases, more than 50 percent of their revenue from selling land to developers, face a collapse in their revenue. Developers stand on the brink of bankruptcy with a glut of unsold homes. Indebted consumers show no appetite to buy more homes in the hope that prices go up. The fundamental problem becomes all the debt associated with this gluttony.
Officially, China’s nonperforming loan ratio stands at a respectable 1.6 percent, accounting for just under 3 trillion yuan. However, these numbers seem questionable under even mild questioning. As a simple example, just the debts of effectively bankrupt real estate developers Evergrande and Country Garden are about equal to China’s official non-performing loan value. Although both developers have nonbank debtors through bondholders, pre-sold units, and suppliers, this gives a picture of the scope of the problem and how data fail to capture the financial risks.
Chinese banks and nonbank financial institutions appear increasingly rickety. Small and midsize banks officially have extremely low capital levels, and even larger banks have imposed cash withdrawal limits. Nonbank financial institutions, known as wealth management product firms, are facing significant pressure, with some stopping redemptions from clients.
The rapid growth of debt over the past 10–15 years encouraged by Beijing policymakers limits options. When facing an unofficial slowdown, Beijing simply ramped up public infrastructure spending and fixed asset lending. Even now, total lending growth outpaces nominal GDP growth by a factor of two. Calls to increase spending further run up against the reality that banks simply lack the capital needed to increase lending by any significant amount.
A recent study by S&P found that even using official data, Chinese banks face a more than $500 billion capital shortfall needed to meet banking regulations by 2025. Even China must ultimately face the reality that banks need repayment to make more loans.
The cold reality is that not only will additional lending accomplish little to stimulate growth, but also China will lack the financial capacity to engage in any significant boost. Furthermore, it’s unclear what it would accomplish. Housing suffers from a supply glut, and oversupply is a major problem across industries and infrastructure projects. It remains unclear whether stimulus would solve or exacerbate the problem causing deflation.
Without hard currency leaking through already tight controls, China can’t count on large financial inflows to stabilize domestic finances. Not only has foreign investment fallen, but also the sheer numbers needed in China dwarf inflows. With a nearly $50 trillion financial services sector, an annual trade surplus of even last year’s record of $877 billion doesn’t approach the sums necessary to help stimulate the economy or stabilize the banks.
So what can China do? The biggest risks to China are in the fragility of the financial system, and the problem is there are no good solutions. If Beijing cuts lending to bankrupt industries, it will effectively allow the collapse of vital sectors that prop up public sentiment, such as real estate and state-owned enterprises. Recognizing the flood of bad loans will require a complicated plan to restructure the banking sector and write down the value of their loans. So far, there does not appear to be the political will to tackle the deep-seated structural problems in the banking sector, making them only worse.
If they are so inclined, they must recognize the significant pain necessary to prevent the problem from worsening. This will require enormous sums of capital to restructure the banking sector and write off large amounts of loans. It will require revaluing large amounts of assets, such as real estate, to value more reflective of the cash flow fundamentals.
For now, Beijing seems more interested in delaying the inevitable choices, choosing to wait and play for time. It’s no longer a question of whether the reckoning will come but how big the adjustments will be.
