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19 March 2019, Gateway House

Chinese economy up against twin bubble

China’s economy is in trouble, a situation that has been exacerbated by the trade war with the U.S. They can either reduce the debt burden and accept slower growth or boost the already high level of debt, which can end in a slump.

Former Visiting Fellow, Gateway House

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China is facing an economic slowdown, a trade conflict with the United States and an economy drowning in debt, all at the same time. Chinese Premier Li Keqiang warned earlier this month that the country is facing a “crucial year”.[1]

Policy-makers in China will have to choose between maintaining short-term growth and longer-term financial sustainability; they cannot have both. Either they will have to reduce the debt burden, which will result in significantly slower growth, or China will further boost its already very high level of debt. The second approach is bound to result in a severe economic slump, although not necessarily a crash. Given the high levels of debt, the bubble in real estate valuations and the opaque linkages between the regulated and shadow-banking sectors, adjustment should probably not be postponed any further.

Borrowing to the hilt

Some observers, such as the Bank for International Settlements (BIS) and the International Monetary Fund (IMF), are growing increasingly wary of China’s economic stability – and its vulnerabilities. Although President Xi stressed in April 2017 that stable financial markets (“financial security”) were an important part of national security and “the basis of stable and healthy economic development”, he left open how this goal should be achieved.

The core of the problem is simple: since 2008, China’s total debt has been growing faster than its economic output, than production. This is a new development. In the 1980s, for example, it was the other way round. China – the government, private companies without a financial sector, private households, reduced their debt. From then until 2008, debt and economic growth moved in parallel. From 2007 to 2014, debt rose from 158% of GDP to 282%.[2]

According to IMF calculations, even the still low government debt will reach 88% of GDP by 2021. Taking into account the risk-weighted debt of state-owned enterprises, China’s public debt will rise to more than 115% of GDP in 2021.[3]

Kenneth Rogoff, Harvard economist and former chief economist of the IMF, in January 2019, described China as the epicentre of the next financial crisis. Rogoff identified over-indebtedness as the main problem of the Chinese economy and noted a widespread under-estimation of China’s economic problems. For too long, the sustainability of debt played no role in the calculations of executives.

 Chinese local authorities and debt

The local authorities – provincial governments and municipalities – implement the central government’s economic guidelines. This has led to a conflict of objectives: the obvious main objectives, namely the prevention of a sharp reduction in employment and the achievement of regional growth targets, are at odds with other policy objectives, in particular, financial stability.

The contradictory nature of Chinese economic policy is reflected in another peculiarity of the financial system, the financing structures at the local level. The local authorities are prohibited by law from going into debt. With the consent of the central government, however, they have been circumventing this ban since 2008 with so-called “local government financing vehicles” (LGFV). These are companies owned by local authorities that offer land use rights as collateral for loans. It is a way of disguising prohibited borrowing, and the municipalities are dependent on this method to finance ambitious urban infrastructure measures.[4]

The rating agency, Standard & Poor’s (S&P), warned in October 2018 that LGFV had built up “a debt iceberg with titanic credit risks” in China. At the end of 2017, the total amount of loans to LGFW exceeded 60% of GDP. S&P expects increasing loan defaults by companies associated with local authorities.

Chinese real estate market’s excesses

Real estate has been the main engine of the Chinese economy. According to some estimates, it accounts (directly and indirectly) for up to 30% of the GDP. The Chinese housing market is characterised by price exaggeration for which there are hardly any examples elsewhere in the world.

Simple dwellings in China are traded for the equivalent of seven-digit dollar amounts. Although prices are high, the quality of apartments is mediocre at best. Chinese citizens pay prices existing in Paris or Zurich for apartments that are as basic and functional as those in the Soviet Union of the 1980s. Citizens must pay 44 times their average annual earnings for an ordinary apartment in a reasonably central location in Beijing. Even Munich, Germany’s most expensive city, seems cheap in comparison – people pay 13 times their annual salary for an apartment there. In the 100 most important Chinese cities, the price per square foot was $202 in 2018. This is 38% more than the median price per square foot in the United States, where per capita income is more than seven times higher than in China.[5]

This is dangerous for the financial system because real estate, both commercial and residential, is the most common form of credit collateral in China. Two-thirds of the total collateral in Chinese banks’ loan books is real estate. A collapse in real estate prices, even a 30 or 40% drop in price levels, is likely to bring the financial system to the brink of collapse.

However, the inflated price level for real estate is not the result of a shortage. Rather, there is a glut of empty apartments. More than 20% of apartments in China are empty. They are neither used by their owners nor are they generating rental income. The only purpose they serve is to store wealth, an asset which may turn out to be a risky bet.

Gigantic twin bubble

The Chinese government is faced with a bundle of economic problems. Since 2007, Beijing permitted the emergence of a gigantic twin bubble – in real estate and in debt. The old recipe – increase debt to boost output – no longer works. China has to deleverage or risk a much larger economic bust in the medium term. Reducing debt without a major loss of confidence in the Chinese economy is a Herculean task.

The country’s leadership faces an unpleasant choice: it either opts for a more sustainable medium-term economic development, which will require a reduction of debt and result in substantial economic hardship in China. Or it chooses to go on yet another borrowing binge in the faint hope that adjustment will be possible at a later stage. Postponing the day of reckoning will only deepen the eventual Chinese financial crisis.

Heribert Dieter is Senior Fellow, German Institute for International and Security Affairs, Berlin & Visiting Fellow, Gateway House.

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[1]  Bradsher, Keith; Buckley, Chris: Facing Slowing Economic Growth, China’s Premier Promises Relief for Business. New York Times, 4 March 2019, available at

[2] Balding, Christopher (2018): Why China Can’t Fix Its Housing Bubble. Bloom-berg, 24 June 2018, available at

[3] Chen, Zhiwu (2015): China’s Dangerous Debt. Why the Economy could be headed for Trouble, Foreign Affairs, Vol. 94, No. 3 (May/June 2015), pp. 13-18.

[4] Ferrani, Benno; Hinojales, Marthe (2018): State-Owned Enterprises Leverage as a Contingency in Public Debt Sustainability Analysis: The Case of the People’s Republic of China. ADB Economics Working Paper Series, No. 534, January 2018, p. 3 and 10.

[5] Song, Zheng Michael; Xiong, Wei (2018): Risks in China’s Financial System. NBER Working Paper 24230, January 2018, available at

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