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Chapter 1 / Major Issues in the Asia-Pacific Region in 2023–2024

Section 3
Risks in the Chinese Economy:
Real Estate and Local Public Finance
KAJITANI, Kai

1. The Real Estate Market Slump and Its Macroeconomic
BackgroundIn the aftermath of China’s ‘zero-Covid’ policy, uncertainty about the future of
the Chinese economy has never been higher. China’s GDP (gross domestic
product) showed a modest recovery in the first quarter of 2023, increasing by
4.5% year on year. On the other hand, the consumption of large durable consumer goods such as automobiles remains sluggish, and the real estate market
remains a major source of economic uncertainty due to an imbalance between
supply and demand for housing, especially in small and medium-sized cities.
Although it seems to have recovered from its temporary slump, the real estatemarket remains a major source of concern for the economy.
In consideration of the above, the purpose of this paper is to analyze trends
in the real estate market, which is the greatest risk factor for the Chinese economy over the medium to long term, and then to reassess the problem fromthe perspective of a “rational bubble” and its demise. The risks faced by local
government finances, which are closely related to the slump in the real estatemarket, are discussed as well.
First, let us examine the aspects of the current real estate market slump. In
February 2020, when lockdowns were implemented in Wuhan and other cities,
the Chinese government swiftly embarked on a policy of monetary easing. This
policy and the implementation of thorough zero-Covid measures to suppress theinfection were initially successful, and the real estate market quickly recovered
to pre-pandemic levels, even showing signs of overheating. In August 2020, thegovernment, fearing growing public criticism of the soaring housing market,
established “three red lines”: (1) an asset-liability ratio of 70% or less, excluding
advances; (2) a net debt-to-equity ratio of 100% or less; and (3) cash holdings thatexceed short-term liabilities. A decision was made not to provide loans to realestate companies that did not meet these conditions. However, as a result of thispolicy, many real estate companies, which had been borrowing at low interest
rates to service their growing debts, began to struggle for funds, and in July
2021, stock prices and corporate bonds of real estate companies plummeted, triggered by fears of default by real estate giant Evergrande Group. In September2. Dynamic inefficiencies and “rational bubbles”
Before analyzing China’s real estate market from the perspective of “rational
bubbles,” we first briefly explain the concept of “rational bubbles” in recent
macroeconomics.
Sakuragawa (2021) pointed out that as long as the economic (GDP) growthrate exceeds the lending interest rate, an asset bubble can persist for a longtime even in a steady-state economy. Such a persistent bubble is referred to as

Part Ⅱ
Part Ⅲof the same year, the average price of new condominiums in 70 major cities in
China dropped for the first time in six years and five months, and the real estatemarket rapidly cooled. The economic impact of the prolonged lockdowns, best
exemplified by the lockdown that was implemented in Shanghai for about twomonths from the end of March 2022, further exacerbated the situation.
In the summer of 2022, the issue of homebuyers refusing to pay their loans
due to the suspension of construction of properties they had already purchased
became a social problem. As a result, the catchphrase for real estate policy
became bao jiao lou, bao min sheng (ensuring delivery of housing and protecting people’s wellbeing). In November of the same year, the “Notice on Financial
Support for the Stable and Healthy Development of the Real Estate Market”(“Article 16: Finance”) was announced, and the policy bank provided special
loans to bao jiao lou, supported developers who had fallen into business risks,and guaranteed financial interests to homebuyers, among other measures tosupport housing construction and prevent further price declines. In January2023, the government reasserted its stance on stabilizing the real estate market
by relaxing the “three red lines” for only 30 major companies (China Research
Office, Research & Advisory Department, 2022). As a result of these government measures, new condominium prices in 70 major cities rose an average of
0.3% MoM in February 2023, marking the first increase in 18 months, however
the housing market recovery still lacks strength.
Apart from the microeconomic aspect of the management of individual realestate companies, the destabilization of the real estate market can be attributed
to three macroeconomic trends: (1) fiscal and monetary policies following theCovid-19 pandemic; (2) the long-term development strategy for China’s urbanization; and (3) the end of the intergenerational resource transfer scheme
through a continuing rational bubble.
This paper focuses mainly on the third trend, which is closely related to the
problems afflicting China’s real estate market. In the following paragraphs, this
topic is analyzed in detail from a macroeconomic perspective.

Part Ⅰ

29

Part Ⅳ

Section 3 / Risks in the Chinese Economy: Real Estate and Local Public Finance

30

Chapter 1 / Major Issues in the Asia-Pacific Region in 2023–2024%
14.0Real average lending rate

12.0

Real GDP growth rate

10.0
8.0
6.0
4.0
2.0

Figure 1-3-1

2022

2021

2020

2019

2018

2017

2016

2015

2014

2013

2012

2011

2010

2009

-2.0

2008

0.0

GDP Growth Rate and Average Lending Rate

Note: The real average lending rate is the weighted average of financial institution lending rates substantiatedby the commodity retail price index.
Source: CEIC Data, National Bureau of Statistics.

a “rational bubble.” Sakuragawa also argues that in a low-interest-rate economy,in which the GDP growth rate exceeds the interest rate, bubbles keep movingfrom one sector to another. For example, after the real estate and stock bubblesof the 1980s ended, a bubble emerged in Japanese government bonds, which isthe cause of Japan’s huge budget deficit.
In China, the GDP growth rate has consistently exceeded the averagelending rate since the Great Recession (Figure 1-3-1). In macroeconomics, asituation in which economic growth exceeds the interest rate under steady-state
conditions is called a dynamically inefficient state. When investment is saturated
in a decentralized economy, the Pareto-optimal allocation of resources among
different points in time cannot be achieved through market transactions, andthere is room for the government and other economic actors to improve thetotal welfare by forcibly redistributing resources. In explaining the resource
allocation problem in a state of dynamic inefficiency, the so-called overlapping
generations model is often used, as in Tirol (1985) and others.
The model assumes that all people live for two periods: ‘youth’ and ‘old age.’In their youth, people work and earn income, and they consume a portion of that
income. In their old age, people live off the savings they accumulated in their
youth. Now consider an economy where investment is saturated, and the rate of
return on real investment is low, i.e. the real interest rate is lower than the rate of
economic growth. To simplify the discussion, we assume that the ratio of people
in each generation is constant. In such a case, young people are forced to saveSection 3 / Risks in the Chinese Economy: Real Estate and Local Public Finance31

under low interest rates for their own consumption in old age (Figure 1-3-2).
Even without the government’s semi-mandatory reallocation of resources,
as described above, this sort of dynamic inefficiency can be eliminated throughthe successive purchase of assets whose value increases in tandem with economic growth, such as real estate assets. In this way, the welfare of all economic
agents can be improved. Tirol proved that in order to achieve efficient intergenerational capital transfers, it is necessary for assets that have no fundamental
value to be traded as having a certain value, and that value tends to expand overtime. This is the situation in which the so-called “rational bubbles” occur.
Old agePart Ⅰ

1st Generation

Revenue : JPY 1,000,000 Consumption: JPY 500,000
Savings: JPY 500,000+ JPY 50,000

2nd Generation

Old age

Revenue: JPY 1,200,000 Consumption: JPY 600,000
Savings: JPY 600,000+ JPY 60,000

1st period

Figure 1-3-2

2nd period

Younger age

Old age

3rd period

4th period

3rd Generation

Asset Formation with Market Interest Rates

Part Ⅱ

Younger age

Part Ⅲ

Younger age

Government
Purchase

Younger age

Government

Government

Government

Redemption

Old age

1st Generation
Purchase

Redemption Purchase

Redemption

Annual income: JPY 1,000,000 Annual consumption:
Bond purchase: JPY 500,000 JPY 500,000 + JPY 100,000

Younger age

2nd Generation

Old age

Revenue: JPY 1,200,000
Consumption: JPY 600,000
Bond purchase: JPY 600,000+ JPY 120,000

1st period

Figure 1-3-3

2nd period

Younger age

Old age

3rd period

4th period

3rd Generation

Cases in which the government issues bonds with interest payments equal to the economic growth rate

Source: Prepared by the author

Part Ⅳ

Source: Prepared by the author

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Chapter 1 / Major Issues in the Asia-Pacific Region in 2023–2024

3. The “Rational Bubble” and China’s Real Estate Market(1) High growth due to excess accumulation of capital
One of the important issues in viewing China’s real estate market as a “rational
bubble” is that “capital overaccumulation” has become the norm as a result of
the high growth of the Chinese economy led by vigorous domestic investment.
Under the Hu Jintao administration this state of excessive capital accumulation became exacerbated. This is attributable to three major factors: (1) adecline in the labor participation rate due to state-owned enterprise reforms andintensified competition among enterprises; (2) an increase in retained earnings(corporate savings) by non-state-owned enterprises that had difficulty borrowing from financial institutions; and (3) a high savings rate by the household
sector due to the delayed development of social security systems (Kajitani, 2012).
In particular, the stimulus packages implemented after the Great Recession
increased the degree of government intervention in the market, leading to whatsome economists have criticized as “national progress and national regression.”
Such stimulus packages combined with excessive fixed capital investment led
by local governments did not bring about a fundamental solution to the problem
of excessive capital accumulation, but instead postponed the problem throughstate intervention in the market.
When the economy is in such a state of “excessive capital accumulation,”the productivity of fixed capital investment declines, consumption is suppressed,and excessive fixed asset investment is sustained, even though economic welfare would clearly increase if current investment were reduced and consumption
were increased. The reason why fixed capital investment keeps growing despite
its low productivity is generally attributed to the fact that earnings = capitalgains (losses) from the rise (fall) in asset prices fill the gap between the time
preference rate and the productivity of investment. On the other hand, in an
economy like China, where the government has strong authority over fixed
asset investment, it is necessary to consider the possibility of excessive capital
accumulation due to aggressive investment activities without regard to government profitability.
As already mentioned, the overlapping generations model theoreticallysuggests that such a state of excess capital accumulation occurs even thougheach economic agent tries to maximize consumption in a decentralized market
economy. When such excessive accumulation of capital occurs, the economy issaid to be in a dynamically inefficient state. Based on an empirical analysis of the
dynamic efficiency of the Chinese economy, Kajitani (2012) points out that thereal estate market is likely to have been in a state of “rational bubble” since theSection 3 / Risks in the Chinese Economy: Real Estate and Local Public Finance

33

Part Ⅱ
Part ⅢPart Ⅳ(2) Inadequacies of the levy-based social security system
As mentioned above, another major determinant of the excessive capital accumulation in China is the inadequacy of the levy-based pension system. China’s
public pension system consists of the compulsory ‘Basic Pension for Civil
Servants and Urban Employees,’ and the voluntary ‘Basic Pension for Urban
and Rural Residents.’ The latter was established in 2014 by integrating the ‘New
Rural Social Pension’ and the ‘Basic Pension for Urban Residents’ for urban
non-regular workers, and it is voluntary. The pension benefit amount is only
one-twentieth that of the Basic Pension for Civil Servants and Urban Employees,
and its insufficient level is problematic (Katayama, 2017).
On the other hand, the ‘Basic Pension for Civil Servants and Urban
Employees’ is a two-tiered pension insurance plan that combines a levy-typecommon fund as the source of the pension with an accumulation-type individual
account. The individual account is a pension account in the employee’s name,and the employee and employer accumulate premiums in proportion to wages.
As shown in Subsection 3.2, it is widely known that when the economy is
dynamically inefficient, intergenerational resource transfers, such as levy-based
pensions, can eliminate the excessive accumulation of capital and thereby raiseeconomic welfare (Futagami, 2012).
In other words, in a dynamically inefficient state, if the government establishes a social insurance system, such as an old-age pension system, andenhances services such as social security, excessive capital accumulation canbe suppressed and the economic welfare of all generations can be improved.
In contrast, if the social security system is not sufficiently developed, excessive
capital accumulation will continue and the economy will be stuck in a dynamically inefficient state.
As already mentioned, China’s current public pension system does not provide sufficient pensions to the peasantry and urban informal workers, who makeup the majority of the population. Even for urban formal workers, pensions that
do not include intergenerational resource transfers are heavily weighted toward
the accumulation system, which does not include intergenerational resource
transfers. If dynamic inefficiency is the cause of the recent asset bubbles in
China, it is clearly due in part to the government’s failure to provide adequate
intergenerational resource transfers, as exemplified by the public pension
system.
In his recent book, Olivier Blanchard argues that in an economy where interest rates, the “safe rate of interest” (the yield on government bonds), remain at

Part Ⅰ

Great Recession.

34

Chapter 1 / Major Issues in the Asia-Pacific Region in 2023–2024very low levels, sometimes below the effective lower boundary of the growthrate and even the real rate of interest (Blanchard, 2023). Blanchard argues thatthe government could improve economic welfare by increasing the issuance of
public debt and conducting aggressive fiscal policy. Applying this argument tothe current state of the Chinese economy, the policy implication would be thatthe government should aggressively spend money, especially to improve theinadequacies of the levy-based pension system and to improve intergenerational
resource transfers.
(3) Real estate ownership as a means of retirement security
Under these circumstances, where intergenerational resource transfers
through levy-based pensions have been insufficient, people have purchased
condominiums in order to secure rent-free accommodation for their retirement.
In addition, relatively affluent urban families often purchase a second condominium for their sons to live in after they get married. This is because parents aswell as grandparents are willing to provide financial support for the purchase of
a condominium, since in present-day China finding a marriage partner is almost
impossible unless the person who is seeking marriage (usually a man) owns acondominium whose price continues to rise (Saito, 2023). At the same time, parents expect their sons and daughters to support them in their old age. Against
the backdrop of such social values, there is empirical evidence that the priceincrease of condominiums is greater in areas with a larger proportion of themale population (Wei et al., 2017).
The strong demand for condominiums in urban areas and the inadequacyof the levy-based pension system have driven the continuous rise in real estate
prices in China since the beginning of this century, and has also been the causeof excessive capital accumulation via vigorous real estate construction.

4. The future of rational bubbles and the problems facing
local finances
It is unclear whether a hard landing in the real estate market and widespread
economic turmoil can be avoided as the overaccumulation of capital in the
Chinese economy begins to dissipate.
From a macroeconomic viewpoint of economic theory, rational bubbles in
the real estate market should theoretically become unsustainable once the overaccumulation of capital is eliminated and the GDP growth rate stops exceeding
the lending interest rate. Even if this happens, it is possible to achieve a certain
level of economic growth while temporarily suppressing people’s dissatisfactionPart Ⅱ
Part Ⅲ

under low interest rates. This could happen either by encouraging intergenerational transfers by widely holding government bonds with low interest rates, orby expanding the levy-based public pension system, which currently only covers
urban full-time employees, to all citizens, as was the case in Japan after the collapse of the bubble economy.
Another concern is the situation of local government finances. The financesof local governments have been largely supported by the sale of farmland andother land holdings. The tightening of the real estate market, as described inthis paper, has caused a significant drop in this income, and the financial situation of many local governments has deteriorated significantly. Some local
governments, such as Hegang City in Heilongjiang Province, are reported tohave cancelled their staff recruitment plans and announced that they were
implementing a financial restructuring plan, effectively “going bankrupt.”
In response to this situation, an editorial in the April 24, 2023 issue of theinfluential economic journal “Caixin Weekly” warned once again that the severe
economic impact of the Covid-19 pandemic, falling prices in the real estateindustry, and various tax exemptions were worsening the debt problems of local
governments. The May 22nd issue of the same journal’s special feature article,“The Debt Issuance Boom of Local Government Financing Vehicles,” points outthat Local Government Financing Vehicles, which have been a breeding groundfor local government “hidden debt,” are increasing their debt through the issuance of bonds known as “municipal bonds,” thereby increasing the risk to local
government finances. According to a think tank’s estimate, at the end of 2022,
local government hidden debt amounted to RMB 52-58 trillion, which is 1.5-1.7
times the amount of official debt outstanding.
Financing through the issuance of “municipal bonds” by Local Government
Financing Vehicles has been used by many local governments since the establishment of Local Government Financing Vehicles to implement economic
stimulus measures after the Global Recession.
However, according to an article in Caixin Weekly, the issuance of more
complex bonds, so-called “structured bonds,” has been a major characteristic ofrecent municipal bond issues.
A typical example is the asset-backed securities (ABS) scheme, in which
Local Government Financing Vehicles uses its own funds to purchase municipal bonds it has issued, posts them as assets, and uses them as collateral toraise new funds. This is strictly regulated as a way to reduce the participationof outside capital and issue bonds at interest rates lower than the market level,
which distorts the market. For example, in 2023, the government issued a notice
restricting new financing by firms whose own bonds account for more than 50%

Part Ⅰ

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Chapter 1 / Major Issues in the Asia-Pacific Region in 2023–2024of the net assets of Local Government Financing Vehicles, and tightened penalties for firms that do not comply with the new restrictions.
At the same time, however, some local governments, such as those in
Guizhou Province, have been experiencing financial difficulties, and it is said
that they are no longer able to resolve their debts on their own. In many cases,
these local financing platforms have asked the local or central government toreschedule (review the repayment terms of) the municipal bonds they haveissued.
In a well-known case, in December 2022, Zunyi Daoqiao Construction Group,
headquartered in Zunyi City, Guizhou Province, defaulted and announced a debt
restructuring that postponed the repayment date by 20 years and only required
interest payments for the first 10 years. It is clear that the state of local government debt is posing risks to the Chinese economy as a whole, and this is aproblem that cannot be left unaddressed.
Some economists in China have pointed out that the reason for this tightness in local government finances is that the central government does not spend
enough money, thereby imposing an excessive burden on local governments,
which is a very plausible explanation.
If the soft landing from the “rational bubble” situation in the real estatemarket is to be achieved, it is necessary to maintain the current rate of economic
growth, to suppress the sharp decline in exchange rates while continuing the
low-interest-rate policy. In the meantime, it is necessary to expand and improve
the social security system while minimizing the level of social unrest that willaccompany the decline in real estate prices. Additionally, since the declining
birthrate and aging population are bound to become more serious and thegovernment’s fiscal burden is expected to increase, it will also be necessary toreview the current fiscal system that places much of the burden, from the provision of social security to economic stimulus measures, onto local governments.
In this context, the decision by the Standing Committee of the National
People’s Congress in October 2023 to issue RMB one trillion in special government bonds and allow a budget deficit of 3.8% of GDP is a notable move. Will thiscatalyze the Chinese government to adopt a more proactive fiscal policy? In any
case, we will continue to keep a close eye on China’s real estate market and local
government finances for some time to come.
References[Japanese]
China Research Office, Research & Advisory Department (2022), “China
Launches Financial Real Estate Support Policies: Caution on Cooling RealPart Ⅱ
Part Ⅲ

Estate Market” (Japanese title: Chugoku wa Kinyumen no Fudosan Shien
Seisaku o Uchidasu –Fudosan Shijo no Hiekomi ni Keikai–), MUFG Bank
(China) Economic Weekly Report, 574th Edition, November 22, 2022.
Futagami, K. (2012), Dynamic Macroeconomics (Japanese title: Dogaku Makuro
Keizaigaku), Nippon Hyoronsha
Kajitani, Kai (2012), “An Empirical Analysis of Dynamic Inefficiency in the Chinese Economy: An Examination Using the AMSZ Criterion”(Japanese title:
Chugoku Keizai no Dogakuteki Hikoritsusei ni Kansuru Jissho Bunseki –MSZ
Kijun wo Mochiita Kento–), Journal of the National Economy, Vol. 206, No. 5.
Katayama, Yuki (2017), “On China’s Pension System (2017)”(Japanese title:
Chugoku no Nenkin Seido Nitsuite [2017]), Nissay Research Institute for
Basic Studies Bulletin, Vol. 62
Saito, Junko (2023), Sin Chinese - Radical Change in Society and Troubled Youth(Japanese title: Shin Chugokujin –Gekihen Suru Shakai to Nayameru Wakamono Tachi–), Chikuma Shinsho
Sakuragawa, Masaya (2021), An Economic Theory of Bubbles: Low Interest Rates,
Long-Term Stagnation, and Financial Degradation (Japanese title: Baburu
no Keizai Riron: Teikinri, Choki Teitai, Kinyu Rekka), Nihon Keizai Shimbun Publishing Co.
[English]
Abel, Andrew B., Mankiw, N. Gregory, Summers, Lawrence H., and Zeckhauser,
Richard J. (1989). “Assessing Dynamic Efficiency: Theory and Evidence.”
Review of Economic Studies, 56, 1-20.
Blanchard, Olivier (2023), Fiscal Policy under Low Interest Rates, MIT Press.
Tirol, Jean (1985), “Asset Bubbles and Overlapping generations” Econometrica,
53, 1499-1528.
Wei, Shangjin, Zhang, Xiaobo, and Yin Liue (2017), “Home ownership as statuscompetition: some theory and evidence,” Journal of Development Economics,
127, 169-186.
[Chinese]Yi, Gang (2021), “The People’s Bank of China, China’s Interest Rate System
and Interest Rate Marketization Reforms,” Journal of Financial Research,
9th period, 2021.

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Section 3 / Risks in the Chinese Economy: Real Estate and Local Public Finance