Xi's Property Fix Has A Local Government Problem

Michelle Lam at Societe Generale SA speaks for many economists when she calls the IMF's own caution here“somewhat disappointing.” The longer Beijing drags its feet on aiming sufficient financial firepower at the property sector, the longer China's economic funk could last.

On Tuesday (September 24), China's central bank announced a series of new policy steps to juice the economy. People's Bank of China Governor
Pan Gongsheng
detailed steps to cut to its key short-term interest rates, increase bank lending to companies and consumers, and lower mortgage rates for existing housing loans.

Pan said another cut in reserve requirement ratios of between 0.25 to 0.5 percentage points may be on the way, too. Overall, though,“the elephant in the room is the property market,” says Xu Gao, chief economist at Bank of China International.“The current policy to stabilize the property market is clearly not enough,” he adds.

Count Xu among those who think 3 trillion yuan will be necessary to stabilize the property sector.

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

Today, the PBOC appeared to heed such concerns, worries validated last week by its decision to stand pat as the Federal Reserve slashed US interest rates by 50 basis points.

In certain ways, Beijing's reluctance to add stimulus in the short-run has had a silver lining. As economist Gabriel Wildau at consulting firm Teneo explains, Xi and Li are prioritizing raising China's competitive game in technology and manufacturing amid trade tensions with the US and Europe.

But recent data on fixed asset investment, industrial production and retail sales suggesting Beijing's 5% economic growth target for this year is becoming more and more of a long-shot seemed to prod the PBOC to act.

At a business forum in Beijing last week, Zhu Guangyao, a former vice minister of finance, said that in the“short term, we must really focus to be sure to successfully achieve this year's 2024 growth goals .” He added that“we still have confidence to reach” this year's 5%.

As such,“there's a good chance that the People's Bank of China will lower rates and banks to lower [benchmark rates] soon,” write analysts at Commerzbank.“Lackluster growth calls for monetary policy easing and the Fed rate cuts provide room for PBOC to cut.”

Without more forceful policy action, the risk of a vicious economic cycle rises. In particular, the plunge in land sales that's currently decimating local governments' budgets could gain momentum. That would make it even harder for municipalities to fund current priorities, never mind buying up excess property to save Xi's administration in Beijing.

Local governments could indeed try to raise funds to bail out housing via special bond issues. But selling ample amounts of local government bonds is only possible if municipal leaders secure enough buyers first. That's easier said than done if investors of all sizes lack confidence in China's financial system.

Yet longer-term reforms are even more important. Efforts to recalibrate growth engines away from exports to innovation and domestic demand-led growth are progressing slower than hoped. The same goes for building social safety nets to prod households to save less and spend more.

The LGFV piece of the puzzle remains a major wildcard. These roughly 4,000 entities created to fund local infrastructure projects carry debts topping $8.5 trillion, by the IMF's estimates.

One challenge is the lack of visibility concerning such debts. Analysts at Fitch Ratings, for example, are skeptical about Beijing's claims that the ratios of LGFV debt relative to local GDP have declined.

Rather, moves to reclassify debt to avoid LGFV status, often to bypass bond issuance restrictions, largely explain this supposed trend.

As Fitch analyst Harry Hu notes, the rating company identified 324 entities, 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 rate 34 of these entities and do not believe there have been any fundamental changes in their business profiles, indicating reclassification was likely to help facilitate bond issuance rather than driven by business transformation,” Hu says.

Yet the LGFV conundrum is a daunting one. In a recent report on the“rise and fall” of these off-balance sheet entities, independent economist Jonathon Sine explains that“a decade ago Beijing not only set out to constrain LGFVs, but to eliminate them. Fiscal restructuring proved insufficient. Today, localities still have dauntingly expansive roles and mandates, will new sources of financing materialize or will they be forced to abdicate?”

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Sine adds that“in this evolving context, will local officials face new incentives to keep their all-purpose handyman, the LGFV, alive and kicking? Will LGFVs wither away, as Lenin once promised the Soviet state would? Who will make them? With a new round of audits sweeping the nation alongside top-down inspection tours and the ongoing anti-corruption campaign, what might become of China's ... LGFVs?”

As 2025 approaches, it's anyone's guess. Suffice to say, though, the extent to which local governments play ball with Beijing will be crucial for property sector stability in the short run.

But finding a longer run solution may require a far more activist response from Beijing - in terms of providing state funding and devising a mechanism to revive non-performing assets.

Another key issue: Xi and Li ensuring expeditious and transparent implementation. That means a bold and clear pivot away from prioritizing economic upgrades.

Over the last two years, Xi's team has ricocheted from pledge to pledge to devise a strategy to take toxic assets off property developers' balance sheets and sharply reduce their ranks.

One possibility about which investors have long buzzed is Beijing adopting a
Resolution
Trust
Company-like
model the
US used to address the
savings-and-loan crisis of the 1980s. That could avoid a Japan-like lost decade as a sector crucial to generating growth gets a new lease on life.

Doing so would afford Xi's reform team
an opportunity to confound the naysayers and reinvigorate
China Inc . It would also make good on Xi's pledges to prioritize the quality of growth over the quantity. And change the narrative on China repeating the mistakes Japan made in the 1990s amid its bad-loan crisis and resulting deflationary nightmare.

For now, though, at least one thing is clear: Beijing's hopes that local governments will snap to attention and obey central orders to buy into the property crisis aren't panning out so far.

Follow William Pesek on X at @WilliamPesek

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