Ting Lu: urbanization+real estate is key to debt resolution

Chief Economist of Nomura Securities China believes believes that rejuvenation of the real estate sector is crucial to arresting an economic downturn.

This article features the speech of Mr. Ting Lu, Chief Economist of Nomura Securities China, from his recent discussion in the New Economist Think Tank Debt Debate (Part Two). The original Chinese version is available on the WeChat blog of New Economist Think Tank.

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I would like to express my sincere gratitude for the invitation from the New Economist Think Tank to participate in this debt debate. I noticed that my colleague Mr. Richard Koo and I are the only two foreign participants, so I feel greatly honored. I have already learned a lot from the speeches of fellow economists, and now I would like to share some of my modest views on the current economy and debt.

Main Reasons for a Weak Economic Recovery

A discussion on debt issues should start with the economy. When the economy is performing well, debt concerns tend to receive less attention; it's only during economic downturns that debt becomes a prominent issue for governments and the public. The reason is simple: numerous defaults have already taken place. Over the past two years, defaults within China were mainly due to real estate enterprises delaying repayment of accounts payable and deferring deliveries of pre-sold homes [properties for which customers have already made down payments and are now faced with monthly mortgage obligations]. There weren't many defaults on interest-bearing debt domestically, but USD bonds issued in Hong Kong by Chinese real estate companies had already seen widespread defaults, which has worsened recently. In the past few weeks, even the USD bonds of some high-quality private real estate companies have plummeted by 80-90%. When there are a lot of defaults, policies from the government and central bank will come under great scrutiny.

First, let me briefly discuss my view on the current economy. Judging from both high-frequency data and other indicators such as PMI, exports, real estate, and second-quarter GDP in the recent period, I believe there is indeed significant downward pressure on the economy. This is the fundamental background to the debt issues. The downward pressure in the coming months may be even greater for two main reasons: first, the summer vacation is drawing to a close, which means that the post-pandemic rebound in consumption is also coming to an end. Second, I believe the massive restructuring in the real estate industry will ripple across Local Government Financing Vehicles (LGFVs), financial institutions, enterprises along the supply chains, and numerous households, possibly leading to a spiral downturn. This tendency has not been contained yet, and it will have a significant impact on China's macroeconomic and financial situation in the coming months.

Next, I will discuss the main reasons for a weak economic recovery.

• First, exports are weak, mainly because most countries outside of China are experiencing economic weakness due to inflation and interest rate hikes, along with the post-pandemic shift in demand structure from goods to services. Weak external demand will inevitably restrain China's economic recovery this year, which may become more pronounced in H2.

• Second, geopolitical issues. Geopolitical risks have significantly increased this year and have already impacted China's economic recovery through various channels, including a decline in foreign direct investment (FDI) and financing in the Hong Kong stock market in the first half of this year. In this regard, it may be difficult to see signs of improvement in the short term.

• Third, lack of confidence among private enterprises. Over the past two years, the confidence of private entrepreneurs have come under major blows, giving rise to operational risks. This could potentially lead to insufficient private investment and also cast impact on the real estate industry, especially in first-tier cities.

• The last factor that needs special attention is the real estate issue. Before its decline, the real estate sector contributed to 25% of GDP and 38% of government revenue. The significant contraction of this industry has a tremendous impact on total demand. In addition, defaults on accounts payable by upstream and downstream enterprises and substantial reductions in taxes and fees related to real estate have triggered a chain reaction, causing the economy to enter a downward spiral. This process will also seriously heighten China's debt problem. The comprehensive debt resolution package that is hotly discussed these days shouldn't be delinked from an in-depth analysis of the real estate sector. How to resolve the real estate issue, whether by soft landing or hard landing, is of paramount importance for future national debt resolution efforts.

Next, let's talk about debt.

I have reviewed some of the discussions in the first debt debate two months ago, and I understand at that time, there was a debate about whether debt is a poison or a panacea. In my view, debt is neither; the impact of debt on economic growth should be examined in a rational and objective manner.

Ever since the Industrial Revolution, the accumulation of savings leading to large-scale investments has been an important prerequisite for modern economic growth. The effective utilization of savings inevitably involves equity or debt financing as intermediaries, and the role of financial intermediaries is to aggregate funds, manage durations, conduct screening and selection, and provide oversight and follow-up. Because equity investments entail complex contracts, the conversion of savings into investment primarily relies on debt financing rather than equity financing, so debt is almost a necessary condition for modern economic growth. Nevertheless, debt will also significantly increase systemic risks.

Debt makes the economic system more complex, and as a result, financial crises and economic fluctuations more frequent. How does this causal link work? Over the past 100 years, economists have, one after another, committed themselves to the study of increasingly indebted economic and financial systems. Researchers such as Irving Fisher, Hyman Minsky, Frederic Mishkin, and Ben Bernanke have revealed the impact of debt on total demand during formation and bursting of asset bubbles. Fisher emphasized the consequences of asset sales after a bubble burst, Mishkin discussed the impact of declining net assets on borrowing behavior, and Bernanke focused on the effect of damaged financial intermediary balance sheets on credit supply after a bubble burst. Minsky, on the other hand, explained the mechanism of bubble formation. According to Minsky, asset price bubbles are an endogenous process, no longer an external shock analyzed by economists for a long time. All of these contributions from economists eventually provided micro-level explanations for the deficient demand theory initiated by Keynes in the 1930s.

Mr. Koo has just discussed his balance sheet recession theory, the essence of which is that if the bursting of an asset bubble leads to severe damage to corporate balance sheets, corporate behavior will change, and their objective will shift from profit maximization to survival maximization; the willingness to borrow will sharply decline and companies will repair their balance sheets through active repayments. the corporate sector undergoes a shift from being a net borrower to becoming a net saver. In the absence of sufficient borrowers within the economic system, there is no avenue for the transformation of savings into the previous levels of investment demand. Consequently, this leads to a decline in overall demand, triggering a chain reaction. Mr. Koo believes that in the case of a balance sheet recession, monetary policy becomes ineffective, that is, a liquidity trap occurs; and in such a situation, the government should act as the ultimate borrower to prevent the economy from spiraling downward by increasing fiscal expenditure and supporting total demand.

Measuring China's Debt Growth

Next, I will discuss several perspectives on China's debt.

First, we need to recognize that China's debt growth over the past decade has indeed been substantial. In recent years, through my discussions and debates with colleagues, I have encountered differing viewpoints among scholars regarding China's post-2008 debt growth. Some argue that it has not surged significantly; they also believe that the central government's fiscal deficit remains relatively low, and that the premature withdrawal of stimulus policies following the Lehman crisis has resulted in a persistent GDP growth decline—which could have been sustained at approximately 8% over an extended period.

However, a more rigorous study of China's debt and deficits will show that the overall debt growth in China was not low, and government deficits were fairly high, especially after the 2008 Lehman crisis. The belief held by many economists that China's debt growth was pronounced during 2015-2018 is, in fact, influenced by misleading data, notably the underestimated actual credit growth resulting from unique data handling methods employed during the local government debt replacement process. This is not to say that China currently lacks fiscal space to stimulate the economy, but rather China should acknowledge its high level of overall debt burden and cherish the space for loose fiscal policy.

China's central government debt is worthy of special attention. Almost all economists agree that China's central government debt is exceptionally low, implying significant policy space. This makes sense, but extra caution is necessary when dealing with data, especially in international comparisons. For example, Who owns the debt of China's giant policy banks? What about the debt of China Railway (CR)? Entities like the CR simply changed their status from a central government department to a corporation. In that case, does it make sense to classify their debt as corporate debt? Furthermore, the People's Bank of China (PBoC) has taken on more fiscal functions over the past decade, such as the Monetary Housing Compensation[ where the government directly compensates the residents of the demolished shanty towns by cash] from 2015 to 2018, which had a scale of 3.6 trillion RMB($493 billion). Is it not central government debt? The PBoC currently has a set of structured instruments that continue to expand its fiscal roles. In addition, among local government debts, the portion approved by the National People's Congress (NPC), totaling around 37 trillion RMB ($5.07 trillion), has the endorsement of the central government, effectively classifying it as central government debt. In short, we must recognize that the actual debt of the Chinese central government far exceeds the nominal figure of 27 trillion RMB ($3.7 trillion). Moving on to the local governments, their debt is mainly related to the LGFVs. This is also the core of the comprehensive debt resolution package. There are various estimates for its size, and 50 trillion RMB ($6.85 trillion) is a relatively conservative estimate.

Balance sheet recession in China?

Finally, I'd like to discuss the fiscal policy of the central government, and especially its role in stabilizing growth and reducing debt. My views are slightly different from Mr. Koo's on this matter. Mr. Koo and I had a detailed discussion in early June, when I told him that his policy advice was very applicable to Japan in the 1990s; I fully agreed with that. However, the problems China faces today are quite different and the solution cannot be simply replicated.

What are the differences?

First, in this round of substantial restructuring in the real estate sector, have Chinese enterprises and residents' balance sheets been damaged? Absolutely, but I believe that so far, it is far less severe than what Japan experienced in the 1990s. During that period in Japan, not only did land prices in major cities plummet by over 80%, but the stock market also witnessed a comparable decline. In contrast, over the past two years in China, although the stock market hasn't shown robust performance, the overall decrease has been relatively restrained, particularly on the main board. While smaller cities in the real estate sector have experienced substantial price drops, the decline in property prices in major cities has remained moderate.

Second, the types of entities with impaired balance sheets are different. In China, three main types of entities have suffered damage to their balance sheets: 1) local governments and the LGFVs due to their reliance on land acquisition and reserves; 2) real estate developers who have purchased a considerable amount of land in recent years, especially in lower-tier cities; 3) residents, particularly those in lower-tier cities who have seen significant declines in home prices. Unlike Japan at the time, entities outside of LGFVs and real estate enterprises in China have not been significantly entangled in the real estate bubble. This is particularly true because industrial land prices in China have remained relatively low and stable. As a result, aside from businesses directly linked to the real estate sector, manufacturing enterprises in China have not been directly impacted by the real estate bubble, marking a significant departure from the situation in Japan during the 1990s.

Thirdly, during the 1990s, many Japanese companies with compromised balance sheets possessed robust international competitiveness. This era witnessed rapid globalization from the 1990s to the early 2000s, during which Japanese companies proactively expanded into international markets, attaining significant profitability. It was the profitability of these Japanese companies, as Mr. Koo noted, that enabled them to pay down their debts and rehabilitate their balance sheets. In contrast, among the entities grappling with balance sheet challenges in China, local governments lack both the willingness and the capacity to settle their debts; real estate developers may exhibit willingness, but they often lack the financial capacity to do so. If residents express a desire to repay their mortgages ahead of schedule, it's not necessarily to repair their balance sheets. Instead, it's often driven by various historical factors, including high existing loan interest rates and the relatively low current market investment returns, which provide an incentive for early repayment.

Beneath these surface distinctions lie deeper differences. Japan is characterized by a small land area, a population roughly one-tenth the size of China's, and by the early 1990s, it had achieved a high level of development, boasting a per capita GDP higher than that of the United States. Urbanization in Japan had already reached advanced stages, and there were no major geopolitical concerns. While Japanese companies may have been somewhat behind in the internet boom of that era, many still held significant international competitiveness. This context allowed the Japanese central government to substantially increase fiscal expenditure without triggering noticeable crowding-out effects on private spending or causing significant resource misallocation.

China, in contrast, must be particularly attentive to the potential crowding-out effects and their consequences. I have recently participated in meetings where there was a consensus on the necessity of significantly increasing central government fiscal expenditure, which aligns with Mr. Koo's recommendation. However, as I told Mr. Koo in our long conversation this June, in specific circumstances, due to the risk of excessive crowding-out effects, augmenting central government fiscal expenditure may not necessarily stimulate current total demand. Additionally, certain policy consequences may be accentuated, particularly when there is still recollection of the repercussions of prior policies. In such cases, these policies could potentially erode investor confidence.

It's crucial to emphasize that China is a vast nation with regions and a population significantly larger than Japan's. Therefore, when the central government allocates fiscal expenditures, it must address the challenge of distributing funds among various regions. China's Monetary Housing Compensation policy from 2015 to 2018, which essentially involved a substantial increase in fiscal expenditure, did indeed provide a short-term boost to the economy. However, due to disparities in resource allocation, population mobility, and deviations from the intended path of urbanization, it has also given rise to numerous challenges currently facing China, including real estate and local government debt issues. There are valuable lessons to be learned from this experience, and I will discuss some of my thoughts on policy next.

Policy Recommendations

First, stop the bleeding. To mitigate the escalating risk of a downward spiral, it is imperative to take swift action, with either the central government or the PBoC stepping in as the lender of last resort. Whether dealing with distressed financial institutions or developers burdened with significant financial obligations, timely intervention is of paramount importance.

Particularly, housing delivery must be guaranteed. From a legal standpoint, the government, in its role as the regulatory authority overseeing pre-sale qualifications and the management of pre-sale funds, holds a certain responsibility for ensuring that developers fulfill their housing delivery commitments. In terms of increasing central government expenditures, allocating resources to guarantee the completion of housing projects serves multiple purposes. It not only stabilizes overall demand but also instills public confidence in the real estate market and ensures social stability, making it a three-pronged approach. At present, the 200 billion RMB ($27.4 billion) refinancing quota provided by the PBoC remains largely untapped. Therefore, it is imperative to address the bottlenecks that have hindered its utilization.

Second, provide oxygen. The central government should provide essential support for the continued functioning of local governments, expediting the evaluation of the repayment and interest payment capabilities of LGFVs and offering timely assistance. However, it is crucial to concurrently reinforce control mechanisms to avert widespread defaults among LGFVs.

Third, activate. China should kickstart its economy by accelerating the progress of ongoing infrastructure projects, with a particular focus on critical projects that span across various regions. It is imperative for China to guarantee the swift and efficient development of infrastructure in cities witnessing net population influx to ensure that national resources do not go to waste.

Fourth, it is essential to focus on the crux of the problem, which is the real estate sector. While some may question whether this approach is merely a repetition of past practices, revitalizing the real estate industry does not necessarily imply a return to old patterns. The fact remains that real estate constitutes a fundamental pillar of the Chinese economy and, as such, must be rejuvenated.

Prior to the recent significant downturn, the real estate sector accounted for a quarter of GDP, nearly 40% of China's total public finances, and almost 80% of household wealth. During previous economic crises, the real estate sector consistently played a pivotal role in driving recovery. For instance, in the latter half of 2016, more than 50% of newly issued bank loans were directed towards the real estate sector. In contrast, during the first quarter of this year, the real estate sector received a mere 6% of these loans. It can be argued that without a rebound in the real estate sector, achieving stability and recovery across the entire Chinese economy will prove challenging.

Some argue that real estate can settle for an "L-shaped" trajectory—declining and then stabilizing. However, this perspective overlooks the complexity of the vast real estate industry. Over the past two years, the entire Chinese real estate sector has experienced a near 50% decline in activity and contributions across various segments. Relying solely on natural stabilization for an "L-shaped" recovery is unrealistic. Policy intervention is essential; otherwise, the real estate sector, local governments, and various associated industries could spiral into further decline.

Fifth, regarding stimulus policies aimed at boosting consumption, I have drawn significant insights from Director Xu Shanda's presentation today. Many scholars suggest that the central government should provide direct financial assistance to the public. However, when the total available funds are limited, the question arises: to whom should these funds be distributed?

In my view, the government has a primary responsibility to support the rural population, particularly concerning pension payments. By my estimate, there are approximately 170 million elderly citizens in rural areas in China aged over 60, with an average monthly pension of less than 150 yuan ($20.55). I believe this group to be the most deserving of subsidies.

Lastly, I'd like to touch on the topic of debt resolution, but only briefly due to time constraints. Given China's current overall debt level and the central government's debt burden, addressing the hidden debt stock of local governments is feasible. However, the crux of debt resolution lies not in tackling existing debt but in establishing a novel mechanism to control the total volume of new debt incurred by local governments during this resolution process.

Therefore, I believe that the pivotal step in debt resolution is to integrate it with urbanization and the real estate sector. China must devise a fresh debt control mechanism, and while exploring and implementing this new approach, the country must concurrently revitalize the economy. Failure to do so would exacerbate the local government debt problem, leaving existing debt unresolved and resulting in more severe debt-related challenges. Additionally, it is essential to pay particular attention to the distribution of debt among regions. Over the past decade, despite substantial efforts to reduce debt, local governments' debt leverage has continued to rise. Furthermore, a significant regional imbalance has emerged, where, on average, economically less developed regions have experienced higher rates of debt growth and increased leverage compared to economically developed regions. This further erodes debt repayment capacities.

To address these two challenges, increasing central government fiscal spending is undeniably necessary. However, what's of paramount importance is the removal of restrictions and the restoration of market-driven resource allocation, including the allocation of funds and land resources. Over the past few years, the Monetary Housing Compensation program has introduced a significant degree of central planning into fund allocation. This, coupled with soft budget constraints and a lack of market-driven oversight and penalty mechanisms, has led to substantial misallocation of funds.

The essence of debt resolution lies in optimizing the efficiency of fund allocation. The allocation of urban land resources across the nation should also incorporate factors such as population migration and other economic indicators as much as possible, with a greater role for market forces. In fact, there is ample room to adjust the spatial layout of urbanization in China. For various reasons, resources have recently tilted towards smaller cities, resulting in inadequate focus on urban development, particularly in the construction of central cities and urban clusters.

China can draw lessons from the collective experience of developed countries, where urbanization and the concentration of population in large cities are inevitable trends. Major cities offer economies of scale and agglomeration effects that are conducive to research and development activities. Specifically, I propose that the supply of residential, commercial, and public construction land in cities should be closely linked to indicators such as employment, registered population, or the number of participants in social security. Given the economies of scale in cities, this linkage model can appropriately favor central cities and urban clusters by increasing the supply of residential land in these areas. By creating expectations of relaxation and anticipated land availability, it is possible to prevent housing prices from spiraling out of control.

Ultimately, resolving the housing price issue hinges on boosting supply. This approach not only enhances investment efficiency but also contributes to the resolution of local government debt.

Of course, the removal of restrictions ultimately involves substantial easing of measures such as price caps, purchase restrictions, and sales limitations in the real estate market. Simultaneously, during this relaxation process, the central government's expansionary fiscal policies should be moderately directed towards cities experiencing rapid growth in registered population. This approach is conducive to advancing urban household registration reform, particularly for assisting rural migrant workers and recent university graduates. Central fiscal allocations tied to Monetary Housing Compensation and affordable housing construction should ideally be correlated with metrics such as population influx and the increase in registered residents.

Professor Chen Huai mentioned earlier that the housing price bubble in major Japanese cities in the late 1980s was attributed to excessive population inflow. I find this to be a subject for debate. There has been some discussion on this topic during today's session, which I believe is beneficial. If the rapid price escalation in Japanese cities in 1991 was indeed a result of population inflow, then one must question: what happened to the population after 1991? Did it experience a significant decline? In reality, it did not; the population in Tokyo continued to rise throughout the 1990s. So, what were the factors contributing to the substantial drop in housing prices in Tokyo during the 1990s? It was precisely what I initially described as a "Minsky moment" – the irrational expansion of debt and leverage.

I firmly believe that China's future economic development should align with trends in population mobility, industrial clustering, and urbanization. A rational urbanization process is also the most effective approach to address local government debt issues.

Q&A Session

Host Li Ke'aobo, Executive Deputy Director of the Institute for Chinese Economic Practice and Thinking, Tsinghua University: Thank you, Mr. Lu, for your insights. You mentioned that addressing the debt issue hinges on economic growth as the foundation, and you stressed the importance of China's vigilance in this regard. Are you apprehensive that, as part of the debt resolution efforts, there might be a resurgence of zombie companies? Do you believe this could potentially harm the market economy? Have you conducted any research on this matter?

Ting Lu: While I haven't conducted an in-depth study on this specific issue, I do believe it's a risk that should not be overlooked. When economists offer policy recommendations to the central government, it's important not to focus solely on advocating for increased central government fiscal spending and higher central government debt. China is a vast country with diverse regions and a large population, which means that careful attention must be paid to how funds are allocated. Inappropriate allocation can lead to significant distortions. During the years of the Monetary Housing Compensation program, a substantial amount of funds didn't naturally flow into cities with promising development prospects through market mechanisms. Instead, due to various administrative allocations, these funds ended up in many cities with limited development potential. This situation caused significant disruptions in the real estate markets in these areas and contributed to the excessive and irrational expansion of some of the biggest private real estate companies, leaving them burdened with massive debt. Ultimately, the whole country had to bear the consequences of these distortions.

Therefore, I believe that when it comes to increasing central government fiscal spending, it's of utmost importance to establish an appropriate allocation mechanism. Furthermore, when expanding central government spending, the Chinese government must be particularly cautious about the crowding-out effect.