• China’s real estate slowdown will require a multi-year restructuring of the balance sheets of property developers, banks, and local governments.
• Defaults by property developers are receiving the most media attention, but over the long run, the problems linked to local government balance sheets may be even more severe.
• Beijing is currently trying to shuffle around losses related to the property market in hopes they can eventually be resolved. However, the only long-term solution to this problem is fiscal reform and nationalizing these debts.

Prevailing Winds is a China-focused blog written by Nicholas Borst, Director of China Research at Seafarer. The blog tracks the economic and financial developments shaping the world’s largest emerging market.

The end of China’s real estate boom will have reverberations across its economy for years. Property development and land financing have been at the heart of China's investment-driven economic model. One of the key questions now is who will bear the losses associated with the slowdown. To better understand the likely answer, examining three sets of interconnected balance sheets is essential: property developers, banks, and local governments.

Property Developers

The impact of the end of the property boom can be most directly seen on the balance sheets of property developers. China’s multi-decade property boom has given rise to a property development industry at a scale unseen in history. As shown in Figure 1, the assets and liabilities of listed property developers are substantially larger than those in other major economies. The liabilities of China’s listed property companies alone, excluding the thousands of unlisted developers, were equal to a staggering 22% of gross domestic product (GDP).

Source: Bloomberg.¹

Many of China’s largest developers, including Evergrande, Country Garden and China Fortune Land, have defaulted on their debts. Many others are facing significant financial stress and are trying to deleverage and sell assets to survive. If the experience of Evergrande is indicative, this process will be difficult. The company’s balance sheet is being crushed as its assets are sold at a discount or written off while its liabilities to banks, bondholders, and suppliers proliferate. As a result, the company now reports a $90 billion deficiency in equity, a euphemistic term for a massive hole in its balance sheet.² China’s troubled developers left a trail of stalled projects and hundreds of billions of dollars of unpaid bills, bonds, and bank debt.³

In the immediate term, the property market is hamstrung by low confidence among prospective homebuyers. Chinese households are understandably reluctant to purchase homes from developers that may go bankrupt and never deliver a finished apartment.

The Chinese government has shifted course and is trying to strengthen the property market through policy changes. However, thus far, these changes have been insufficient, and overall demand for property remains weak. In addition to the current short-term challenges, housing in China faces many long-term headwinds. These include declining demographics, reduced investment demand for housing, and excess supply that needs to be worked through by the market.

These factors don’t necessarily portend a collapse in the housing market. Demand may eventually stabilize as older housing stock is torn down and replaced with newer units. However, the property boom in China over the past two decades is unlikely to return. Property developer balance sheets will likely face pressure to restructure and consolidate for many years. The developers who do not survive this transition will leave massive amounts of unpaid debts in their wake. Many of these losses will flow directly onto the balance sheets of China’s banks.

Banks

Having lent enormous amounts to China’s property developers, banks are acutely vulnerable to the turmoil affecting the real estate market. So far, the losses have been mostly implicit and hidden. The Chinese government has instructed banks to roll over many loans for property developers and lower their interest rates rather than putting them into default.⁴ This effort to “extend and pretend” bad property loans imposes losses on the banks through the opportunity cost of lost interest income, but it does not force them to recognize losses from bad loans.

Even with forbearance, it is likely that a significant number of losses will need to be explicitly recognized at some point. While nobody knows what the property loan losses will be, some insight can be gained by looking at banks' loan books.

Figure 2 shows the distribution of bank exposure to the property market, according to a UBS estimate. Exposure to the property market (loans, bonds, and shadow credit) equals around one-third of bank lending.

Relative to the roughly $10 trillion in direct property-related credit, commercial banks have about $925 billion in loan loss provisions and $3.5 trillion in Tier 1 capital, as shown in Figure 3.

Source: CEIC.

The good news for Chinese banks is that more than half of their property exposure is mortgage lending. China’s relatively strong household balance sheet and high down payment requirements provide banks with a significant buffer from mortgage delinquencies. Fitch recently estimated that the loan-to-value ratio for Chinese residential mortgages was between 40 to 60%.⁵ This implies that mortgage delinquencies, at the aggregate level, may not overly impact bank balance sheets. It’s not all good news for banks, however, because of the complicated situation involving millions of unfinished housing units across China.⁶ There are no official statistics on the number of unfinished presold units, but the problem is worrying enough that the central bank has set up special lending facilities equal to around $75 billion to help finish incomplete units.⁷ 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.

The latest banking stress test from the People's Bank of China (PBOC) incorporates an increase in property-related defaults as part of its overall analysis. In these scenarios, banks face an increase in troubled assets across various fronts. This is done because banks often face a correlated rise in non-performing loans (NPLs) and other types of financial stress. Figure 4 shows the scenario outlined in one of the most severe shocks tested.

As shown in Figure 5, in the scenario outlined above, China's largest and systemic banks' aggregate capital adequacy ratio drops modestly but remains at a reasonable level (12.78%). However, the results for the nearly 4,000 smaller banks included in the stress test are much more severe. Their aggregate capital adequacy ratio is cut nearly in half. On a per-bank basis, nearly 64% of small banks would see their capital levels fall below regulatory minimums.

Source: People’s Bank of China.

While the stress test shows China's systemic banks retaining healthy capital levels, the results should be interpreted cautiously. The scenarios being tested by the PBOC may not be severe enough to capture the financial damage from a multi-year correction in the property market. Additionally, it's clear that smaller banks are much more vulnerable to a property downturn. Financial distress among many small banks may reveal weaknesses and dependencies in other parts of the financial system. Most importantly, missing from the stress test is an analysis of the close links between the balance sheets of banks, property developers, and local governments. As will be discussed below, the problems related to local government debt are significant and could spill over to much higher rates of default than projected.

Local Governments

Over the long run, the most significant impact of the end of the property market boom will be on the balance sheets of local governments. This is because land has served as an essential asset for local governments to finance investment and development. Since fiscal reforms in the 1990s, local governments have been structurally short on cash. However, they have a monopoly over a critical resource – land. 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. The LGFVs, in turn, used the land as collateral to borrow from banks or issue bonds. LGFVs used these borrowings to engage in two primary activities: land development and infrastructure construction.⁹

Land development consists of preparing a plot of land for industrial, commercial, or residential use. The LGFV usually makes a land transfer payment directly to the local government. If there are occupants on the land (often farmers or low-income residents), the local government must compensate and resettle them. This compensation and resettlement often requires significant expenditures, often around 80% of the amount that the land was sold for.¹⁰ After resettlement, the land is developed by demolishing old buildings and establishing basic municipal infrastructure (power, sewers, roads, etc.). After this, the land is sold to property developers to build homes, shopping malls, commercial parks, or office complexes. Figure 6 shows a stylized model of this process, both in the financing and repayment phases.

Source: Seafarer.

Another primary focus for LGFVs is infrastructure construction. In this case, a local government transfers the LGFV land without requiring payment because the land will be used to provide a public good. The LGFV can borrow against the value of the land to build an infrastructure project. Sometimes, the LGFV will be able to commercialize the land around the new infrastructure (such as a subway line) to help offset the costs. The infrastructure project will be sold back to the local government, the local government will pay the LGFV ongoing service fees, or the LGFV will be able to operate the infrastructure as a concession (such as a toll road). Figure 7 shows a stylized model of this process, both in the financing and repayment phases.

Source: Seafarer.

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 financial holes in the balance sheets of LGFVs with financial difficulties.

Ephemeral Balance Sheets

The borrowing activity of LGFVs straddles a deliberately murky line between government debt and corporate debt. Local governments often claim that LGFV debts are off-balance sheet and that their creditors have no recourse back to the local government. Most other observers disagree, viewing LGFV debts as disguised government borrowing. The IMF projects for 2024 that local government-financed vehicle debt is 65.9 trillion Renminbi (RMB) ($9.26 trillion), equivalent to around half of China’s GDP.¹¹

How much of this debt is at risk? Some light on this can be shed by looking at the aggregate financial statements and balance sheets of LGFVs. A UBS analysis of LGFV income statements shows that around 65% of LGFVs can service the interest on their debts outright.¹² Another 23% can service their debt with help from a subsidy from the local government.

However, there are significant flaws in using an income-accrual based approached. This is because LGFVs recognize income, often accounts receivable from the local government, but do not receive actual cash flows. If these receivables are unpaid or the subsidies from the local governments are reduced, a significant portion of LGFV debt will default. On a cash basis and without a subsidy from the local government, only 19% of LGFVs are able to service the interest expenses.

If LGFVs cannot service their debts from their income, can they instead sell off assets to repay their borrowings? According to the financial reports of nearly 2,000 LGFVs listed in Wind Information, the average liability-to-asset ratio of these entities is 56%.¹³ Theoretically, LGFVs should have sufficient assets to pay their debts. A study by the IMF estimates that LGFV assets are roughly divided 50/50 between physical and non-physical assets.¹⁴ The physical assets include land, inventories, and equipment. The non-physical assets include accounts receivable from the government, equity investments, and intangible assets. Figure 8 presents a stylized model of an LGFV balance sheet.

There are several weaknesses associated with the asset side of LGFV balance sheets. First, they are reliant on land prices remaining high. There is evidence that LGFVs are keeping land prices artificially strong by buying land to offset a decline in demand from developers.¹⁵ Second, the receivables from the local government sitting on the balance sheet of LGFVs are likely to be written down or extended if the local government is facing financial pressure itself. Finally, items such as intangible assets and unlisted equity stakes in other companies (usually state-owned enterprises (SOEs)) are easily manipulated. Because these items are assigned values that are not transparently determined by the market, they can remain at artificially high valuations long after losses have been recognized.

All of this implies that LGFV balance sheets should be viewed skeptically. Despite reporting assets well in excess of their liabilities, many LGFVs would likely find it difficult to sell their assets and pay off their debts. In terms of both income and assets, LGFVs are likely to need help to service their debts.

Deciding Who Will Bear the Losses

One thing that is clear from the analysis above is that local governments have created a complicated structure of financial interconnectedness between themselves, LGFVs, local banks, and local state-owned enterprises. As shown in Figure 9, when local financial institutions are involved, the local government may have control of all of the entities involved and, as such, has considerable ability to direct financial transactions among the various parties. In instances where national banks are making the loans, local governments are less likely to have sway over the bank.

Source: Seafarer.

The slowdown in China’s economic growth and the decline in demand for land are increasingly putting pressure on LGFV balance sheets. In the absence of any outside support, a large percentage of this debt will become non-performing. However, large-scale LGFV defaults are not inevitable because local governments have several options available to allocate the losses. One option that has already begun to occur is forcing banks to bear some of the LGFV losses implicitly through the opportunity costs. Banks are lowering the interest on LGFV loans, extending their maturity, and allowing LGFVs to borrow more to pay off old debts. This creates a large drag on the banks as they have a large amount of their assets tied up in low-interest loans to LGFVs that may never be repaid. It might also impact the overall economy as banks have less ability to extend credit to new borrowers.

Another strategy available to local governments is to leverage the crossholdings between local SOEs and LGFVs. Under the direction of the local government, local SOEs may inject capital into LGFVs, purchase their assets from them at inflated levels, or take on the losses of LGFVs directly by absorbing their debt onto their own balance sheet. These activities allow losses from LGFVs to be shifted onto the balance sheet of local SOEs, who may be in a comparatively stronger financial situation.

The problem with the approaches described above is that they do not solve the underlying problem. Shifting around the losses from LGFVs to banks or SOEs may buy a short amount of time, but the scale of the losses will likely be too large for either of these groups to absorb.

Even if local governments were willing to recognize all the debt of their LGFVs, most of them lack the fiscal capacity to do so. Only a grand fiscal bargain, in which local governments get a greater share of tax revenues, or Beijing takes on a higher share of expenditures, will provide local governments with the financial strength to clean up their LGFV debts.¹⁶ 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.¹⁷ However, these amounts pale in comparison to the trillions of dollars of LGFV debt that remains.

End of an Economic Era

China's economic growth miracle of the past two decades has been strongly linked to a historic property market and infrastructure boom. The end of this cycle and the long tail of losses it will produce will dominate Chinese economic policy for years to come. The balance sheets of property developers, banks, and local governments are all under significant pressure. Who is ultimately forced to bear the losses stemming from the end of the property boom will tell us much about the direction of fiscal reform in China and how the country’s economic model might change.

A downward spiral in growth and local finances can be avoided, but it is contingent upon Beijing establishing a long-term sustainable fiscal structure for local governments and helping them clean up the mess of LGFVs.

The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.

As of December 31, 2023, the Seafarer Funds did not own shares in the securities referenced in this commentary.

1. Data accessed on December 27, 2023. Includes firms under the industry classification of Real Estate as well as the sub-industry Homebuilders.
2. “2023 Interim Report.” Evergrande Group, September 26, 2023.
3. Feng, Rebecca, and Cao Li. “China’s Problem with Unfinished Homes Keeps Getting Bigger..” The Wall Street Journal, November 19, 2023.
4. Chuan, Du. “China Extends Support to Ensure Property Developers Stay Afloat.” Yicai Global, July 11, 2023.
5. “Chinese Banks and RMBS Could See Minor Impact from Push to Lower Mortgage Rates.” Fitch Ratings, August 1, 2023.
6. Cheng, Evelyn. “China’s Unfinished Property Projects Are 20 Times the Size of Country Garden.” CNBC, November 14, 2023.
7. “The State Council Information Office Press Conference on Financial Statistics for the First Half of the Year (国务院新闻办就今年上半年金融统计数据情况举行发布会).” Central People’s Government of the People’s Republic of China (中华人民共和国中央人民政府), July 14, 2023.
8. “China Financial Stability Report 2022.” People’s Bank of China, March 19, 2023.
9. Lam, Brian, and Jameson Zuo. “Identifying and Picking a Quality LGFV.” Pengyuan Credit Ratings, March 28, 2020.
10. Wu, Fulong. “Land Financialisation and the Financing of Urban Development in China.” Land Use Policy, Volume 112, January 2022.
11. “People’s Republic of China: 2022 Article IV Consultation.” International Monetary Fund, February 2, 2024.
12. Yan, May, Catherine Yang, Chloe Wang, Ning Zhang, John Lam, Alex Ye, and Helen Li. “APAC Focus: Is LGFV Debt a Potential Drag on Bank Earnings & Capital?” UBS, May 29, 2024.
13. Wind Information. Data accessed November 30, 2023.
14. Hoyle, Henry, and Phakawa Jeasakul. “Local Government Financing Vehicles Revisited.” International Monetary Fund, February 4, 2022.
15. Feng, Allen, and Logan Wright. “Tapped out.” Rhodium Group, July 10, 2023.
16. Borst, Nicholas. “China’s Balance Sheet Challenge.” China Leadership Monitor, March 2, 2023.
17. “China to Replace $140 Bln LGFV Debt with Local Bonds.” Reuters, August 11, 2023.