China’s Financial Risks and Prospects(U.S.-China Relations Study Group Commentary No.14)
Fukumoto Tomoyuki
Professor
Osaka University of Economics

1. Excessive debt in China’s non-government sector and financial risks
China’s non-government sector debt levels are quite high by international standards. Outstanding
corporate and household debt has exceeded twice the nominal GDP since 2016. So far, China has
been able to contain the emergence of major financial risks. However, in the way that Japan and Spain,
having reached similar levels in the past, experienced bubble bursts and financial instability, it isimpossible to definitely say that China will not experience a similar situation. In particular, the current
economic downturn triggered by the Zero-COVID policy and the real estate slump are causing thefragility and faultline of China’s financial system to become apparent in some local cities, and thecountry has entered a phase that requires caution.
When looking at financial risk in China, it is not enough to assess risk in the banking system; inaddition, we need to look at shadow banking risk, hidden local government debt risk, real estate risk,and their interconnectedness. Of these, the biggest key is real estate risk. The real estate recession has
been going on for 18 months. If there is a major nationwide drop in real estate prices and a massive
chain reaction of real estate developer failures, there would be a tremendous impact on the banking
system, shadow banking, and local debt problems.
Below is an overview of the current status of each of the above risks, with the exception of
shadow banking, whose balance continues to decline due to stricter regulations by the authorities.

2. Banking system risksFirst, we look at risks to the banking system. The ratio of non-performing loans (NPLs) of commercial
banks remained low at 1.66% at the end of September 2022. It should be noted that after the outbreakof the Novel Coronavirus pandemic, the reality of NPLs has been hidden by government guidance
encouraging companies to defer repayment of their loans. Nevertheless, with banks carrying loan loss
provisions twice as high as their NPLs, and with resilient profitability (commercial banks’ net income
up 12% year-on-year in 2021 and up 1% year-on-year in January-September 2022), it is unlikely thatsystemic risk will materialize anytime soon.
However, the management of financial institutions located in some provinces where economic
conditions are poor and the real estate recession is severe is a situation that is generally considered tobe getting tougher. After the failure of Baoshang Bank in Inner Mongolia in 2019, the management
crisis of Bank of Jinzhou Co., Ltd. in Liaoning province and Hengfeng Bank in Shandong province1was revealed one after another. In 2022, there was a bank run on Henan province’s rural banks, which
had collected high interest deposits through fraud. Although the government-led handling and rescueof these cases and the protection of depositors have reduced the contagion of risk in each case, theemergence of management crises at small and medium-sized financial institutions at the local level islikely to continue to occur sporadically in the future.
The government has taken steps in the past, such as dispatching finance-savvy executives from
central ministries and state-owned banks to the local areas and allocating part of the funds obtained
from the municipal bonds it issues to recapitalize local banks, but this measure is still insufficient. To
this end, the government plans to create a Financial Stability Law and establish a financial stability
guarantee fund.

3. Risk of hidden local debt
Next, consider the risk of hidden local debt: even after the 2014 amendment to the Budget Law of thePeople’s Republic of China allowing local governments to issue local bonds, the growth of hidden
local debt through local government financing vehicle (LGFV) has not been halted. An IMF staff
report released in February 20231 projects that the debt-to-GDP ratio of LGFV will reach 47% in
2022 and rise further to 66% in 2027. With the Ministry of Finance of the People’s Republic of China
controlling the issuance of local government bonds, local governments have no choice but to use
LGFV under instructions to increase infrastructure investment as a stimulus measure.
With fiscal revenues falling due to the economic downturn and real estate recession, the financial
condition of local governments has been deteriorating, and some local governments and LGFV havebegun to reveal concerns about debt repayment: in December 2021, the fiscal restructuring plan ofHegang city, Heilongjiang province, was revealed, and in October 2022, the default of Lanzhou’s
LGFV on the Chengtou municipal bonds occurred. And in January 2023, a 20-year repayment deferralof the bank loan of Zunyi city, Guizhou province’s LGFV was announced. The Central Economic
Work Conference in December 2022 increased vigilance on the local debt problem, calling for “effortsto prevent and defuse local government debt risks, decisively curbing the increase and resolving the stock.”

4. Real estate risks
Currently, real estate risk requires the most attention, primarily because a serious real estate recession
has been going on for a year and a half. Prices for housing in China, especially in the major cities,
have soared to levels that are considerably higher than those in the rest of the world in terms of annual
income multiples. In addition, as much as 40% of the local government’s gross fiscal revenue comesfrom the sale of land, and it is believed that in many cases, real estate development has been carriedout in the countryside without reflecting actual demand.
1International Monetary Fund, “2022 Article IV Consultation; Staff Report for the People’s Republic ofChina,” February 3, 2023.
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Based on the policy that “housing is for living, not for speculation,” the Xi Jinping regime
imposed debt ratio regulatory requirements for real estate developers and property lending
concentration rules for banks beginning in late 2020. The introduction of the rules and regulations ledto a rapid cooling of the real estate market. However, the introduction of the rules and regulations
was only a catalyst; what is more important is the structural change of declining actual demand. The
population of the main group of first-time homebuyers (aged 25-34) has already begun to decline andis expected to drop by 70 million from its peak by 2030. In July 2022, cash-strapped real estatedevelopers were forced to halt construction of homes that were sold before they were built in thepresale model, and in response, homebuyers refused to pay their mortgages in various locations.
When this trouble became news, buyers became increasingly reluctant to purchase homes due toconcerns about the risk of halting home construction, further exacerbating the cooling of the housing
market.
The government has been gradually easing regulations and providing support measures for realestate. Among these, the financial support measures announced in November 2022 were more indepth than those announced in the past. Nevertheless, it cannot be denied that the government is still
postponing the problem and waiting for demand to recover. This is because the government
encourages the deferment of repayment of loans and bonds for real estate developers that are comingdue. The IMF estimates that more than 20% of listed real estate developers in China are insolvent if
actual real estate prices are taken into account.2
With the majority of homes in China transacted through the presale model, housing demand will
be slow to recover unless real estate developers’ business concerns are resolved. It appears necessary
for the government to utilize the state-owned sector (state-owned banks, state-owned asset
management companies, and state-owned developers) to promote fiscal restructuring and processing
reorganization of real estate developers.

5. Prospects for financial risks in China
As we have seen above, management problems of local financial institutions, local debt problems,and management issues of real estate developers will continue to surface sporadically. The
government is expected to respond to these problems so that they do not spill over into systemic risk.
The Chinese government has strong control, including the use of the state-owned sector, and it isunlikely that a large-scale bubble burst and financial crisis will occur in the foreseeable future.
Nevertheless, a prolonged slowdown in the economy and a protracted slump in the real estate market
will certainly increase vulnerability to the financial system. China’s financial risks require furtherattention.
2International Monetary Fund, “Global Financial Stability Report October 2022,” October 11, 2022

[https://www.imf.org/en/Publications/GFSR/Issues/2022/10/11/global-financial-stability-reportoctober-2022].
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