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Logan Wright is the director of China markets research at Rhodium Group and senior associate of the Trustee Chair in Chinese Business and Economics at the Center for Strategic and International Studies. Wright is an expert on China’s financial system, and over the years he has studied the expansion of credit in China, the Chinese government’s deleveraging campaign, and local government debt. In the following lightly edited interview, we discussed China’s unbalanced economic recovery following COVID, the deepening debt crisis among local governments, and the global impact of a structural slowdown in China’s economic growth story.

Q: How would you judge China’s economic performance since the reopening after COVID-19?

A: China’s recovery has almost entirely been driven by services activity, and by consumption; that is, by household consumption, and by pent up demand for travel. What’s notable is that the other components of the recovery that had been expected to rebound, such as property and private sector business investment, have continued to lag. The flattering growth rates don’t make a lot of sense when some of the key components of the economy are still dramatically underperforming, and are still a drag on growth rather than contributing this year.

The recovery by all accounts has been weaker than expectations, but the [headline] data has met or exceeded expectations so far. How do you square those two things? How far below headline data should we be thinking about growth? What is the gap? There’s a very reasonable argument that growth was negative in 2022, that the economy contracted. It’s obvious that investment was negative, even headline consumption was negative. There was some positive growth from net exports. But there’s been a far more significant slowdown in China’s economy relative to what’s been declared. Companies, businesses, and investors are aware of the spread between the official version of the data and reality. But it’s an open debate about how long that will persist, and whether that will turn around anytime soon.

Why haven’t we seen more of a bounce back in the property sector yet?

There’s this common misperception out there that the three red lines [a policy that China’s government introduced in August 2020 to restrict borrowing and reign in ballooning debt levels among Chinese property developers] caused the property sector adjustment and that the property slowdown was essentially something that Beijing did intentionally. It’s completely fair to say that Beijing was uncomfortable with the scale of the property market within the economy and [wanted to] squeeze the bubble before it got larger. But no one anticipated the severity of the adjustment after the three red lines were put in place.

All of a sudden, you’ve shifted from a market in which supply [of property] was rising, to a period in which supply overtook previous peaks that were based largely on investment-driven or speculative demand. This was a highly vulnerable structure for developer financing, and for the overall imbalance within the market. Now, we’re seeing an adjustment back to more sustainable levels. We would argue that we’re probably overshooting those levels on the downside, which can happen as long as private developers are in severe financial distress. 

People do not realize the extent to which all of the problems between the property sector and local government debt, fiscal capacity, and banking sector stress are all linked.

The People’s Bank of China [China’s central bank] has mechanisms to try to channel credit to private developers, but they have been very inadequate and ineffective. Private developers face huge risk aversion within the financial sector, meaning they can’t get access to credit. Therefore, they’re reducing land purchases [from local governments]. We’re down over 90 percent in terms of what they’re buying. Now, there are signs that state-owned developers are starting to fill in the gap and are starting to come back to the market. And I would expect more of that to take place. So that’s where the floor will be once construction slows to a certain level.

And what are you seeing among consumers? Has something fundamentally changed about how people view the property market? 

The basic consumer story is that throughout the pandemic there were no mechanisms [used] to improve household incomes, unlike in the rest of the world. The focus of Chinese stimulus was on companies and restoring their access to credit, and production. There have been some subsidy programs for rural consumption — for purchasing cars, appliances, and things like that. But those generally only pull demand forward rather than change the overall demand function for these products. You’ve also had this huge hit to service sector enterprises, and small business confidence — years of revenue wiped out for some of these firms that had to shut down. That takes time to repair, and that confidence has not been restored so far. 

The recovery has been very tepid. That has hit incomes, capacity to consume, and income growth. The expectation at the start of the year was for consumption growth well above pre-pandemic rates. It was based on this idea that there was this huge pool of excess savings that Chinese households had accumulated. But that was really a misread of the [bank] deposit data — much of which was concentrated among the very wealthy. Those people were not going to consume much in any case, but the basic story has been the slow recovery in the private sector, the slow recovery of small business, and the corresponding uncertainty that generates in terms of household incomes and household spending. 

Can you explain China’s deleveraging campaign and how has it shaped China’s modern economy?

It’s impossible to separate the growth performance of the previous decade from China’s unprecedented expansion of credit — unprecedented in global and historical terms. The growth of China as a single country banking system relative to global GDP was larger than any country that we have seen in at least the last 100 years. 

This credit expansion was sustained by a widespread moral hazard within the system, [due to an assumption] that all of these assets were [ultimately] guaranteed [by the government]. The deleveraging campaign was essentially an attempt to grapple with the growing complexity of the Chinese financial system and the growing risk that had been produced when it [the financial system] was expanding much faster than the real economy. 

That credit expansion was done through a lot of regulatory arbitrage, via the shadow banking system. From 2012 to 2016, you went from a system in which banks were very large and inefficient but stable. They took deposits, largely from households, and made loans to state-owned enterprises. Those continued to fund investment, and the banks also had a very steady inflow of deposits from China’s external surpluses, both its trade and capital account surpluses. That’s a very stable base of funding. 

By 2016, all of those fundamentals changed. The marginal source of growth and funding for the banking system from then on started to come from wealth management products (WMPs) not deposits. [WMPs are investment products, usually offered by banks, that offer higher returns than regular deposits, usually by investing in riskier credit instruments. Only a small proportion of these are officially consolidated on balance sheets as banks’ own liabilities, but investors usually viewed the products as being offered directly by the bank]. The rise of WMPs coincided with booming interest in speculative products in Chinese markets. In 2016, the daily turnover in Chinese commodities markets was exceeding daily turnover on the S&P 500. There was a massive amount of speculation in virtually anything that would generate yield, and it was unsustainable. 

The deleveraging campaign [from May that year] was an attempt to grapple with this shadow banking growth. Beijing first used monetary tightening instruments to unwind a lot of these leveraged bets in wealth management products, and to squeeze the capacity of the shadow banks to expand, creating a big slowdown in overall credit. 

But there’s no way to cut credit roughly in half without impacting significant volumes of borrowers and types of borrowers. So as a result, you started to see a lot more credit risk materialize. You saw not only peer-to-peer lending networks collapse, but smaller banks like Baoshang in 2019, quickly extending to Jinzhou and Hangfeng and other banks. You saw trust companies collapse in 2020. You saw local state-owned enterprises default on their loans, like Yongcheng Coal in late 2020. You saw property developers default in 2021. You saw defaults on individual mortgages in 2022. And now we’re looking at the specter of local government financing vehicle (LGFV) defaults. These default risks and credit risks are getting closer and closer to the core of the system.

Can you explain how LGFVs work? And why is the prospect of LGFVs defaulting so concerning to local governments?

LGFVs were created en masse right after the global financial crisis [in 2008]. These were new financing platforms where local governments could use land [that they owned] as equity to borrow from banks to start funding investment projects. Therefore, without using up fiscal resources, local governments could start catalyzing investment very rapidly using these new structures. The LGFVs were thus companies that were backed by land sales and other local government revenues, but they were not explicitly on the balance sheets of central or local governments. 

Even so, they essentially locked in credit problems for Beijing — you don’t want to ever cut these things off from funding, because if you stop funding them, you immediately stop investments in projects before they’re actually completed. Through the rise of local government financing vehicles, we started to understand the scale of the Chinese stimulus effort. It became obvious that you had this huge, unfunded central and local government liability existing in a parallel, quasi-fiscal space outside of government balance sheets. Generally, they were a way to bypass borrowing limits at a time when local governments were less able to borrow directly via issuing their own bonds.

For various local governments, if the debt burden for LGFV debt becomes too extreme, then they end up absorbing significant proportions of fiscal resources. We found a significant proportion of cities in China are paying more than 10 percent of their overall fiscal resources to help fund LGFV debt. In a few cities, over 50 percent of available fiscal resources is going towards paying for interest on LGFV debt. 

Then we started to see quiet cries for help. The city of Guiyang [the capital city of China’s southwestern Guizhou province] published a report [that was quickly taken down] online basically saying that the situation had risen to a level where they could not continue operating, and that they needed some central government assistance. There were similar posts about distress in Hohhot, in Inner Mongolia. 

What does that tell you? This is essentially a game of chicken. This is gamesmanship. Local governments want to avoid being the first to say that they have a huge problem. But once one or two local governments say that they have an enormous problem, it dramatically reduces the threshold for the third, fourth, fifth and sixth local governments to raise their hand and say, ‘we also need help.’ It’s very much the logic of banking crises — every bank failure is a one-off until there’s so many one-offs that people realize there’s a broader problem, and that you’re going to have to step in with government assistance in some form. 

The issue right now is not just a stock problem of how to restructure the 60-plus trillion yuan [$8.3-plus trillion] in LGFV debt. The issue is what role will local government investment play in the future of China’s economy.

This is the conundrum. Beijing might get dragged into a restructuring because all of these local officials forced them into it. 

So there is no simple solution for local government debt problems?

People do not realize the extent to which all of the problems between the property sector and local government debt, fiscal capacity, and banking sector stress are all linked. They’re all basically the same problem, which is that the previous investment-led growth model has reached its limit, and cannot continue to generate the same returns. How can you finance that debt sustainably at interest rates above 1 percent? You really can’t, unless you want to run persistent and large fiscal deficits indefinitely, because ultimately the financial returns to these investments are insufficient to sustain them on a commercial basis. So they continue to generate new contingent fiscal obligations for either central or local governments.

And if you can’t finance that, why are you continuing to pour resources into this channel for growth? The issue right now is not just a stock problem of how to restructure the 60-plus trillion yuan [$8.3-plus trillion] in LGFV debt. The issue is what role will local government investment play in the future of China’s economy. How much will it slow? Can you get a more sustainable financing mechanism for those forms of investment? And how is that going to be funded? 

Local governments are responsible for so much expenditure, but do not have corresponding control of the revenues. The sources of fiscal revenue in China are extraordinarily leveraged to the investment-led growth model and are drying up. Even without considering the impact of land sales at the local government level, China’s two largest sources of tax revenue are value-added taxes, which are heavily tied to manufacturing and the export sector, as well as enterprise income tax. Individual income taxes and domestic consumption taxes are much smaller. If you look at tax revenue as a proportion of GDP, we have fallen about six percentage points in just eight years. There are ways that you can restructure the tax system around a consumption-led economy, but those have not been done. You need to change that balance in very short order to make it more sustainable.

There’s a larger problem between China’s fiscal obligations, in the form of debt service and pension obligations for its rapidly retiring and aging workforce; and China’s fiscal ambitions, whether we’re talking about military modernization or strategic modernization of the economy. The reality is that the [tax] revenue base is declining over time. This is a deteriorating situation. I don’t think people understand how this is going to impact the way in which we think about Chinese state capacity to influence the economy through credit and fiscal mechanisms.

All of this seems to paint a fairly bleak picture of China’s economy. Is there a more optimistic way to read the data you’re seeing?

The irony is that we’re probably among the more optimistic forecasters for next year. In many ways, the picture we’re describing here is a structural one, it is the end of this credit-led growth model, and it will be replaced by something else. We don’t know how productivity-enhancing those new drivers of growth will be. We know the labor supply is declining. We know the capital formation rate is going to be heavily impacted by the stress within the financial system. And we know we’re likely to find some sort of bottom in the property sector. This could have been a five- to eight-year adjustment in the property sector. Instead, it’s going to be a two- to three-year adjustment. And you can easily see property contributing cyclically to growth, even within the context of never recovering to previous peak levels of property construction or sales. 

The second aspect is inventories overall. China typically has a very cyclical inventory, a stocking, restocking, and destocking cycle consistent with the business cycle overall, which is heavily dependent upon global demand trends. There’s no science to this, but destocking cycles typically last 18 to 21 months or so. And we’re about 13 to 14 months into this current one. By the middle of next year, it’s very reasonable to assume we’ll start to see opportunities to re-accumulate inventory. Obviously, a lot of that depends upon global demand, but we could see that normal, cyclical aspect start to contribute to growth next year. Then we’ll be further along in the services and consumption led recovery. 

Have China’s economic woes pushed it to the negotiating table with the U.S.?

It’s probably not a coincidence that China cut interest rates recently, seemingly abandoning the strength of the reopening narrative, just as it set up meetings with [Secretary of State Antony] Blinken and Bill Gates. There’s been a lot of signaling from Beijing that they still want foreign investment. They still want inbound portfolio flows. Outflows from China are inevitable, the capital inflows are more contingent. If you want stability in the domestic financial system, you have to constantly be worried about the pace of inbound foreign direct investment. 

But the Party is also looking at the external narratives around China’s economy. The data may not have not been enough this year to restore confidence that the economy is on the right track. And they now might need to send some contrary signals to the rest of the world after launching investigations into Mintz Group, Bain and Company, and others earlier this year. 

The Biden administration has recently been pushing a narrative that it’s de-risking not decoupling from China. Do you think Beijing understands or cares about that distinction? 

I don’t think Beijing necessarily cares. But that doesn’t mean that it’s not a very substantive and meaningful distinction. Beijing will probably say that they don’t like either of these things. 

Beijing may view decoupling and de-risking as roughly the same. But for companies, de-risking literally means we’re not trying to back away from the market entirely. We’re not trying to end trade relations between China and the rest of the world. We’re trying to take steps that effectively insulate our economies and our supply chains from the kinds of disruptions that China has used as tools of economic statecraft in the past. That’s the growing concern [in Beijing]. I do view it as a substantive distinction in terms of how it’s being portrayed. It’s not just rhetorical or semantic. That doesn’t mean that Beijing will view it or portray it any differently. 

What does a slowing Chinese growth story mean for the U.S. and for the rest of the world in the coming years?

China’s slowdown is going to create a lot more uncertainty about China’s future positions. It’s going to be more difficult to maintain alignment between the U.S. and the G7, and between business and government, precisely because the signals are not going to be super clear. Beijing will both be sending occasional signals that they’re reopening, and will be rekindling efforts to reform, in part because nothing else is working. Some people will take those signals and run with them and say that they’re very significant. Others will downplay them, and say that they’re not meaningful at all. 

Beijing will both be sending occasional signals that they’re reopening, and will be rekindling efforts to reform, in part because nothing else is working.

The more interesting thing from our perspective is that for the United States, none of the challenges that China poses are likely to be impacted by China’s relative growth rate. In other words, whether China’s GDP is 75 percent of U.S. GDP or 105 percent does not really make a difference in terms of how policymakers should think about the economic challenges that China faces. Nor does it suggest that fundamental adjustments in U.S. policy are necessary. 

China is not going to reach 150 percent or 200 percent of U.S. GDP. That won’t happen. It is impossible. That’s not fully internalized in the debate around China, not only in Washington DC but in other global capitals. That’s what the structural slowdown really means. It means that the calls for fundamental changes in policy to counter fundamental threats are going to look less and less critical as China continues to slow, and as China looks more reactive than proactive in shaping the narrative about their economy.

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