A Financial Crisis in China Is No Longer Unthinkable
Extensive fiscal and financial imbalances have taken China, its leadership and the world into uncharted territory
By Greg Ip
The International Monetary Fund envisions China’s growth averaging 4% over the next four years, down from its projection of 4.6% a year ago. PHOTO: CFOTO/ZUMA PRESSThe world’s second-largest economy has a deflating property bubble, local governments struggling to pay their debts and a banking system heavily exposed to both.
Anywhere else these factors would be seen as precursors of a financial crisis.
But not in China, conventional wisdom goes, because its debts are owed to domestic rather than foreign investors, the government already stands behind much of the financial system and capable technocrats are on top of things.
Conventional wisdom might be dangerously out of date.
True, an imminent meltdown like the global panic that followed Lehman Brothers’ failure in 2008, is highly unlikely.
Yet China’s fiscal and financial imbalances are so large that they have taken the country—and, because of its size, the world—into uncharted territory. We simply don’t know how well the Chinese economy, and a leadership now concentrated in the hands of President Xi Jinping, can navigate these strains.
The scale of the problem emerges from a series of reports issued last week by the International Monetary Fund.
First, while China reported a stronger than expected economic growth of 4.9% in the year through the third quarter, its medium-term outlook has plainly deteriorated.
The IMF sees the country’s growth averaging just 4% over the next four years, down from its projection of 4.6% a year ago.
This makes it far harder to grow out of its debts than when growth was 10%, over a decade ago.
Second, the IMF has also boosted projections of Chinese government deficits, which they now see swelling from 7.1% of gross domestic product this year to 7.8% in 2028.
Among major economies only the U.S. comes close, which isn’t exactly reassuring.
The problem isn’t with the central government but local governments that borrowed heavily via off balance-sheet financing vehicles to fund urban development projects.
Their liabilities now equal 45% of GDP and including them in China’s government debt would vault the total to 149% of GDP by 2027, above Italy’s at 141%.
Local Chinese governments have struggled to service their debts as land sales, a primary source of revenue, have dried up. Indeed, the IMF estimates 30% of local government financing vehicles are “non viable without government support.”
This is a big problem for China’s banks, which hold roughly 80% of that debt.
Just half the cost of restructuring that debt would saddle them with impairment charges of $465 billion—chopping 1.7 percentage points off the ratio of loss-absorbing capital to assets, the IMF estimates.
Chinese banks, relative to their global peers, aren’t that well capitalized to start with.
And a recession would deplete that capital significantly, as stress tests the IMF conducted on banks around the world illustrate.
For China, the IMF simulated an adverse scenario in which growth averages 1% instead of 5% for three years and property values decline.
The result: Chinese banks’ capital ratios would plummet from 11% last year to 7.1% in 2025, the worst of any region under the stress tests.
There’s also the potential for feedback loops: As loan losses mount, banks lend less.
Local governments, unable to borrow, slash investment and social services.
Economic growth and property values weaken further.
How likely is any of this?
Financial crises in Latin America in the 1980s, southeast Asia in the 1990s and the euro area in the 2000s were greatly amplified by the exodus of foreign capital.
By contrast, China is a net lender to the world and tightly controls inflows and outflows of capital.
Its debts are owed to itself.
Chinese banks are also mostly owned or controlled by the central or local governments that would presumably not let them fail, precluding bank runs and panics.
In China’s last bout of banking trouble 20 years ago, bad loans were transferred at par value to state asset-management companies.
But sometimes financial crises occur because local, not foreign, investors flee.
Nor are they always fast and violent, like the global financial crisis from 2007 to 2009.
Some unfold over years as occurred in Spain in the 1970s, the U.S. (with its savings-and-loan institutions) in the 1980s, and Sweden and Japan in the 1990s.
The origins of China’s big debts are in many ways a textbook case of moral hazard.
Developers and local governments were able to borrow so much because lenders assumed Beijing would bail them out.
But that assumption is based on implicit, not explicit guarantees, and that ambiguity is potentially destabilizing.
Logan Wright, director of China research at Rhodium Group, a research firm, said a financial crisis in China wouldn’t originate with an external shock or sudden revaluation of assets to reflect lower market prices.
Instead it would happen when investors who assumed the government stood behind their assets learn that it doesn’t.
“Financial markets then need to reprice these risks rapidly,” he said.
For example, “The property sector was previously considered too big to fail, until Beijing’s own policy priorities were suddenly perceived differently.
Then credit risks emerged very quickly as more and more developers’ finances were viewed more skeptically.”
As the government’s implicit backing is withdrawn from peripheral assets, investors might assume it no longer applies to core assets such as small banks, mortgage loans and then local governments, Wright said.
“That’s the potential path to crisis.” he said.
Chinese officials are well aware of these risks and have taken tentative steps to restructure local government debts and prod troubled developers to finish projects.
But the debts are too large and growth too slow for China to sweep bad loans under the rug as it did 20 years ago, said Martin Chorzempa, a China expert at the Peterson Institute for International Economics.
He also worries that under Xi, the quality of governance has deteriorated.
“I’m concerned about an exodus of talent, a reduction in economic indicators being published, a reduction in space in China for economic debate.
Those things all make me concerned they might not be getting the full picture.”
What does this mean for the rest of the world?
A multiyear financial quagmire that depresses Chinese consumer confidence would sap demand for imports while swelling exports, pressuring foreign producers.
And while contagion is circumscribed by the limited connections between China’s financial system and the rest of the world’s, that system is still, in absolute terms, gigantic.
Should it start to flail, the ripple effects are certain to be felt abroad.
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