Over the past two decades, property and infrastructure investment have been essential to China’s economic growth. With the end of the real estate boom, China’s land-driven development model is now unwinding. Property developers, banks, and local governments must all restructure their balance sheets in response to a slowing market. If the process is not managed carefully, it will act as a substantial drag on China’s economy for years to come and could create financial instability.

PROPERTY DEVELOPERS

The financial impact from the end of the real estate boom can be most directly seen on property developers. Many of China’s largest developers have defaulted on their debts or face a significant liquidity crunch. These financial pressures have created a massive number of stalled projects and hundreds of billions of dollars of unpaid bills, bonds, and bank debt.

In the near term, things look bleak for most developers. Chinese households are understandably reluctant to purchase homes from developers that may go bankrupt and never deliver a finished apartment. The Chinese government is trying to support the property market, but its efforts have been insufficient so far, and overall demand for property remains weak. Looking forward, real estate in China faces many long-term headwinds, including declining demographics, reduced investment demand for housing, and excess supply. 

While these factors don’t necessarily portend a collapse, they indicate that China’s housing market is facing a significant restructuring and will grow much more slowly in the future. Property developers will face pressure to deleverage and sell assets to survive as this process unfolds. The developers that fail to make this transition will go bankrupt and leave massive amounts of unpaid debts in their wake. 

BANKS

Banks are acutely vulnerable to the turmoil affecting the real estate market, having lent enormous amounts to homebuyers and property developers. Chinese banks have $7.5 trillion in loans directly linked to the real estate market outstanding. Banks also have exposure to the property market through developers’ bonds and shadow banking channels such as trusts and entrusted loans.

…bank balance sheets depend on restoring homebuyers’ confidence and completing the glut of unfinished apartments.

The good news for Chinese banks is that most of their property lending is in the form of household mortgages. China’s relatively strong household balance sheet and high down payment requirements provide banks with a significant buffer from mortgage delinquencies. Fitch estimates that the loan-to-value ratio for Chinese residential mortgages is between 40 and 60 percent, a low number that provides protection for banks. 

However, the situation is more complicated than it initially appears due to the millions of unfinished housing units across China. There are no official statistics on the number of unfinished presold units. Still, the problem is worrying enough that the central bank has set up special lending facilities equal to around $77 billion to help finish incomplete units. Households that have pre-purchased unfinished units may stop paying their mortgages if they believe their homes will never be built, as many briefly did during the summer of 2022. As a result, bank balance sheets depend on restoring homebuyers’ confidence and completing the glut of unfinished apartments.

LOCAL GOVERNMENTS

The most significant long-term effects of the property market slowdown will be on local governments. Land has served as an essential asset for local governments to finance investment and development. Since fiscal reforms enacted in the 1990s, local governments have been structurally short on cash. However, they have a monopoly over a critical resource — land. Land has served as a key resource, allowing local governments to borrow against it and sell it for revenues. After the Global Financial Crisis, local governments began to pledge, transfer, or sell the land under their control to local government financing vehicles (LGFVs) on a massive scale. LGFVs used these borrowings to engage in property development and infrastructure construction.

The LGFV-driven investment cycle has supercharged China’s economic growth, providing infrastructure, jobs, and revenue for local governments. As long as land was an appreciating asset, credit was available for LGFVs to borrow. Even if the economics of a project were suspect — many infrastructure projects will never pay for themselves — rising property values could undergird the stability of the loan. Local governments could develop land and sell it to property developers, often turning a profit in the process. Rising land values allowed local governments to plug holes in the balance sheets of LGFVs with financial difficulties. 

During the past two decades of a booming property market, LGFVs have run up significant debts without the ability to pay them back. LGFVs have minimal cash flows, and their balance sheets are stuffed with inflated assets. Without outside support, a significant portion of this debt will become non-performing. The IMF estimates that two-thirds of LGFV debt will need to be recognized as government debt. For 2023, that amount was projected to be $9.2 trillion, equivalent to around half of China’s GDP. 

THE NECESSITY OF FISCAL REFORM

Beijing faces a dilemma: it is reluctant to bail out LGFV debts, but it fears the financial volatility that would occur if LGFVs started to default in large numbers. Local governments have tried to buy time by shifting losses to other LGFVs, state-owned enterprises, and banks. Given the size of the problem, this approach is not sustainable. Even if local governments were willing to recognize all the debt of their LGFVs, most of them lack the fiscal capacity to do so.

The only long-term solution is a new grand fiscal bargain in which local governments receive a greater share of tax revenues, and Beijing takes on a higher share of expenditures. This would give local governments the financial strength to recognize and clean up their LGFV debts. Fiscal reform would allow LGFV debt to be recognized and restructured, converting short-term loans and bonds into long-duration government debt. This occurred at a small scale in 2023, with local governments issuing around $140 billion in bonds to repay LGFV debts. Yet, these amounts pale in comparison to the trillions of dollars of LGFV debt that remains. 

Absent reforms to revive the property market and resolve LGFV debts, China’s economic recovery will continue to disappoint.

The main barriers to fiscal reform appear to be political. Beijing values the control it wields from controlling an outsized share of tax revenues and transferring it back to the provinces as it sees fit. Independent and sustainable sources of revenue for local governments might threaten that control. Nonetheless, a downward spiral in growth and local finances might force the central government’s hand. 

In China, the property market and the fiscal system are deeply intertwined, and both are in need of urgent restructuring. Absent reforms to revive the property market and resolve LGFV debts, China’s economic recovery will continue to disappoint.

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