Xi Jinping's Real Estate Reform Poses a Problem for Local Government

Xi Jinping's boldest attempt yet to revive China's housing crisis is running into an unexpected obstacle: local government leaders who appear not to have gotten the memo.

Headlines surrounding the measures announced four months ago focused on the central bank's 300 billion yuan ($42.5 billion) in liquidity to buy up unsold homes. But the real aim of the program was to encourage local authorities to absorb the housing oversupply on a much larger scale across the country.

So far, however, fewer than 30 of the more than 200 mainland cities Beijing had hoped to encourage have heeded the call. That raises a fascinating question: Are city officials lagging behind, or is their inaction the result of a bigger picture that Xi’s team has failed to grasp?

It may well be the latter. True, local government officials do not tend to advance in Communist Party circles by defying Beijing. On the contrary, municipal cadres tend to succeed by producing economic growth rates and development indicators that are higher than the national average.

Yet local authorities grappling with an aging workforce are likely to understand their balance sheets better than Premier Li Qiang's or Finance Minister Lan Foan's teams in the nation's capital.

And this Beijing-ordered property-buying spree could clash with the excess debt of local government financing vehicles (LGFVs) that already poses a challenge for municipal authorities across the country.

According to a Bloomberg survey of 15 Chinese analysts, more than half of them believe the country's real estate woes could persist for another two to five years. If so, the deflationary forces weighing on China could become even more entrenched.

And, as Japan continues to demonstrate today, deflation becomes increasingly difficult to eradicate over time.

Last month, Xi's team rejected a proposal from the International Monetary Fund (IMF) to deploy central government funds to complete unfinished real estate projects in Asia's largest economy. The IMF recommended a budget increase of nearly $1 trillion.

The 300 billion yuan bailout plan unveiled by Beijing in May falls far short of the 1 trillion to 5 trillion yuan that some leading economists say is needed to resolve the property crisis.

The IMF has been careful to warn Beijing against any expectation of future government bailouts and thus against any moral hazard, as Zhang Zhengxin, the IMF’s executive director for China, puts it. Xi Jinping’s party, Zhang argues, should continue to apply market principles and the rule of law to complete and deliver these units.

Michelle Lam of Societe Generale SA speaks for many economists when she calls the IMF's caution somewhat disappointing. The longer Beijing delays investing sufficiently in the real estate sector, the longer China's economic crisis could last.

On Tuesday (September 24), China's central bank announced a series of new political measures People's Bank of China Governor Pan Gongsheng detailed measures to cut its key short-term interest rates, increase bank lending to businesses and consumers and reduce mortgage rates for existing home loans.

Pan also said that a further reduction in the reserve requirement ratio, by 0.25 to 0.5 percentage points, could be considered. But overall, the major problem is the real estate market, said Xu Gao, chief economist at Bank of China International. The current policy to stabilize the real estate market is clearly not enough, he added.

Xu is among those who believe that 3 trillion yuan will be needed to stabilize the real estate sector.

Earlier this month, former PBOC Governor Yi Gang turned heads by saying that Beijing officials should focus on combating deflationary pressure through proactive fiscal policy and accommodative monetary policy.

Today, the PBOC appears to have heeded those concerns, concerns validated last week by its decision to hold its ground as the Federal Reserve cut U.S. interest rates by 50 basis points.

In some ways, Beijing’s reluctance to increase its short-term stimulus has had a silver lining. As economist Gabriel Wildau of consultancy Teneo explains, Xi and Li are prioritizing improving China’s competitiveness in technology and manufacturing amid trade tensions with the United States and Europe.

But recent data on fixed asset investment, industrial production and retail sales, suggesting that Beijing's 5 percent economic growth target for this year is becoming increasingly distant, appear to have prompted the PBOC to act.

At an economic forum in Beijing last week, Zhu Guangyao, a former vice finance minister, said that in the short term, we really need to focus on making sure we successfully achieve the 2024 growth targets. He added that we still have confidence in reaching 5% this year.

So there is a good chance that the People's Bank of China will lower rates and that banks will lower their interest rates. [benchmark rates] “Soon,” Commerzbank analysts write. Sluggish growth calls for monetary policy easing, and Fed rate cuts give the PBOC room to cut rates.”

Without more forceful policy action, the risk of an economic vicious circle is growing. In particular, the decline in land sales that is currently decimating local government budgets could accelerate. This would make it even harder for municipalities to finance their current priorities, let alone buy up surplus properties to save Xi Jinping’s administration in Beijing.

Local governments could indeed try to raise funds to bail out the housing sector through special bond issues. But selling large quantities of local bonds is possible only if municipal leaders can first find enough buyers. That’s easier said than done if investors of all sizes lack confidence in China’s financial system.

But longer-term reforms are even more important. Efforts to shift growth away from exports toward innovation and domestic demand are progressing more slowly than expected. So are the social safety nets designed to encourage households to save less and spend more.

The LGFV remains a major unknown. These approximately 4,000 entities created to finance local infrastructure projects have debts amounting to more than $8.5 trillion, according to IMF estimates.

One challenge is the lack of visibility into these debts. Fitch Ratings analysts, for example, are skeptical of Beijing’s claims that the ratio of LGFV debt to local GDP has declined.

Rather, this alleged trend is explained by measures aimed at reclassifying debt in order to avoid LGFV status, often to circumvent bond issuance restrictions.

As Fitch analyst Harry Hu notes, the ratings firm identified 324 entities, or about 8% of the 4,000 entities, that by June 2024 were no longer classified as LGFVs on a widely used Chinese bond data platform.

We assess 34 of these entities and do not believe there have been any fundamental changes in their business profile, indicating that the reclassification was likely to facilitate bond issuance rather than being driven by corporate transformation, Hu said.

Yet the LGFV dilemma is a significant one. In a recent report on the rise and decline of these off-balance sheet entities, independent economist Jonathon Sine explains that a decade ago, Beijing sought not just to limit LGFVs, but to eliminate them. Fiscal restructuring proved insufficient. Today, local governments still have extremely broad roles and mandates. Will new sources of funding materialize, or will they be forced to abdicate?

Sine adds that in this changing context, will local officials face new incentives to keep their jack-of-all-trades, the LGFV, alive? Will LGFVs disappear, as Lenin promised the Soviet state? Who will make them? With a new round of audits sweeping the country, top-down inspection tours, and the ongoing anti-corruption campaign, what might become of China’s LGFVs?

As we approach 2025, no one really knows to what extent local governments will play ball with Beijing. That said, the stability of the real estate sector in the near term will depend on the extent to which local governments play ball with Beijing.

But finding a longer-term solution may require a much more active response from Beijing, in terms of public financing and designing a mechanism to revive non-performing assets.

Another key point: Xi and Li must ensure rapid and transparent implementation. This means clearly and boldly abandoning the priority given to economic modernizations.

Over the past two years, Xi Jinping's team has made promises to craft a strategy to remove toxic assets from real estate developers' balance sheets and dramatically reduce their ranks.

One possibility that has long been raised by investors is that Beijing will adopt a Resolution Trust Company-type model, used by the United States to resolve the savings and loan crisis of the 1980s. That could prevent a lost decade like Japan's, as a sector crucial to generating growth could be given a new lease of life.

This would give Xi Jinping’s reform team an opportunity to outmaneuver opponents and reinvigorate China Inc. It would also deliver on Xi’s promises to prioritize the quality of growth over quantity. It would also help change the narrative that China is repeating the mistakes Japan made in the 1990s, amid the bad-debt crisis and the resulting deflationary nightmare.

For now, however, one thing at least is clear: Beijing's hopes that local governments will sit up and obey central orders to invest in the real estate crisis have yet to materialize.

Follow William Pesek on X at @WilliamPesek