China's property market will enter the final stages of market clearing next year. Slowing economic growth will continue to strain the country's heavily indebted local governments. S&P Global Ratings believe these forces will further polarize credit risks across China's banks, LGFVs, and homebuilders. Beijing's new measures may not be enough to resolve these pressures.

Cities with lower income and greater dependence on land revenues are more at risk. Many are already highly indebted and will not be able to counter slowing growth with large stimulus.

These pressures will hit different banks very differently. Large national banks will perform much better than smaller regional lenders, especially those in weaker regions. Although the debt swap program--at a reported size of Chinese renminbi (RMB) 2.3 trillion--will reduce some repayment pressures on local government financing vehicles (LGFVs), it won't get the banks off the hook.

We conveyed these views in our China Credit Spotlight Conference, held on Oct. 19, 2023, and present the key takeaways in the frequently asked questions below. The opinions draw on the lively discussions in the conference's featured panel: "Property and LGFV Debt--Implications for Banks."

Questions discussed include:

• Will the property market finally turn around?
• Will more localities and LGFVs fall into distress?
• How will the banks be affected? Are their nonperforming loan (NPL) data reliable?
• How will investors navigate these risks?
• Will the new policies fix the local debt problem? Is it positive for LGFVs?
• What is the one takeaway from your on-the-ground visits this year?

A replay of the webinar is available here.

Frequently Asked Questions

Will the property market finally turn around? Will banks keep lending?

Real estate (Lawrence Lu):  Sales in tier-one cities fell 31% year on year in July and 29% in August. This drop was significant. It hurt business and consumer confidence and became an obstacle to China's economic recovery. For this reason, policymakers will continue to roll out stimulus, at least until housing markets in the largest cities stabilize. They still have tools available, such as more cuts in mortgage rates and further relaxation of down-payment requirements and home-purchase restrictions.

Sales in top-tier cities started to pick up in September. In 2024, we expect the housing market to enter the final stages of market clearing, with a sequential recovery starting with top-tier cities, followed by the lower-tier cities. Sales will drop by 10-15% this year but will decelerate to a 5% decline next year.

On whether banks will continue to lend to the developers, the answer is yes and no. For select large and financially sound developers, especially state-owned, the banks will continue to lend to them. However, as the market downturn enters its final clearing-out stage, there could still be sporadic defaults. The banks will remain cautious, especially in lending to private developers.

Will more local governments and LGFVs fall into distress?

Local governments (Susan Chu):  The prevailing divergence story will continue next year. Cities with lower income and greater dependence on land revenues are more at risk.

That said, weak property markets are not the main challenge. Local governments can mitigate fiscal pressures from lower land revenues by reducing land development activities and costs. Growth and structural risks present the bigger challenge. Many cities are already highly indebted and will not be able to counter slowing growth with big stimulus.

LGFVs (Laura Li):  The likelihood of LGFV default is higher than in the past couple of years. In our view, entities with 5%-10% of sector debt--we estimate the sector debt was around RMB60 trillion at end-2022--were facing impending liquidity strains amid broad liquidity weakening of the whole LGFV sector, as of mid-2023. The subsequent local government special refinancing bond issuance of over RMB1 trillion helps boost the market confidence temporarily, but primarily for LGFV public bonds. The weakest part of the sector may run into distress; the government may not be able to support all entities. This is reflected by continued LGFV distress cases for non-conventional debt and bank loan restructuring.

Chart 1

Chart 2

How will the banks be hit? Are their NPL data reliable?

Banks (Ryan Tsang):  The banks' performance will be polarized, as these pressures will hit different banks differently. Large national banks will perform much better than some of the smaller regional lenders--especially those operating in regions with weaker economies.

Aside from these asset-quality issues, rate cuts, early repayment of mortgages, loan repricing, and strong deposit growth are also putting pressure on net interest margins. Such factors will weigh on the banks' profitability over the next couple of years.

That said, problem loans, defined as special mention loans, NPLs, and forborne loans, will trend down gradually next year. This is despite continuing stresses in the property and LGFV sectors, with recovery in other sectors driving this improving trend.

From what we've seen in 2020 and 2021, the cure rate for Chinese banks' forborne loans was high. Even if we apply a big haircut on that rate, it will still drive improvement in asset quality for some banks. For loans to property developers, however, NPLs and special mention loans will likely rise over the next few years, primarily due to the tightened loan classification rules published earlier this year.

As for reliability, numbers presented by the large banks are reliable--these institutions stick to the loan classification requirements. The lower-tier banks may take a more flexible approach. To account for such effects, we look at indicators beyond reported NPL ratios to assess asset quality. We also adjust the official numbers to come up with our own nonperforming asset number.

For example, we group NPLs and special mention loans together to get an overall picture of a bank's asset performance. We also make sizable adjustments to banks' stated forborne loans, mindful that regulators can give banks a lot of leeway on this measures. Our adjustments can add a lot to our estimates of nonperforming assets (NPAs). Lastly, we add 0.7% to the official NPL rates as a catch-all adjustment. Our NPA numbers will likely trend down to 5% in 2024 and stay at that level in 2025.

How will investors navigate the risks embedded in the property, LGFV, and bank sectors?

Investor view (Eric Liu, BlackRock):  Risks will diverge across and within sectors. For real estate, we are cautious. Housing market sentiment is still fragile, since households are concerned about their income. Privately owned enterprises are more at risk, given their refinancing conditions are weak, home buyers are still cautious in buying from them, and state-owned enterprises continue to take their market share.

LGFVs' risks may be more neutral. The sector's fundamentals are weak due to diminished revenues from land sales. However, we weigh these factors with the strong willingness of local governments and the financial system to support these entities. This support should stay in place for at least one to three years.

The market will likely treat with caution weak LGFVs from weak regions. That said, the new "basket of measures" may lead to turn-around opportunities for some.

For banks, we are more cautious than last year. Under current central government plans, the banks will take some of the burden of the LGFVs. They are likely to cut interest rates on loans to the LGFVs. We are yet more cautious on weaker banks.

On the flip side, China's central bank may offer more support to the banking sector, perhaps through cuts to the required reserve ratio, or deposit rates.

Will the new LGFV policies fix the local debt problem quickly?

LGFVs (Laura Li):  Probably not. The new package of policies will likely be a realignment of existing policies, including bank-loan restructurings and swaps of LGFV debt using local government bonds, all amid tightened financing regulations.

Yet, these measures will likely not be enough. The central government may need to do more. Similar measures so far have proved insufficient to resolve the sector's debt problem.

The various local governments face different obstacles and development needs. LGFV debt resolution is only one priority among many that vie for local government debt quotas. Some localities have assets, but views vary on how strategic they are and if they should or could be monetized in time to deal with the LGFVs' debt repayment needs. Some distressed cases so far show that having such assets have not helped alleviate the LGFVs' debt pressures.

Local governments (Susan Chu):  China will limit the amount of local debt contained within what it calls "officially recognized hidden debt," which Beijing started to estimate since 2018. We already factor in such debt in our credit assessments of localities. The reported RMB2.3 trillion local government-for-LGFV debt swap program is within those estimates, so they will not impact those credit assessments.

It is also not clear if RMB2.3 trillion is enough to resolve the local debt problem. Local governments have the capacity to issue up to another RMB8 trillion of debt, in our view. This is only a third of the level three years ago, implying that localities need to reduce spending much more than before. Given China's economic slowdown, most of this debt-raising capacity will likely be used for stimulus rather than LGFV debt resolution.

Banks (Ryan Tsang):  The debt-swap program will reduce some LGFVs' repayment pressures, but it won't get the banks off the hook. It has no material rating impact on the big banks because their exposures are well managed. Regional banks, however, have bigger and more concentrated exposure. A third of their LGFV loans are linked to lower-level governments such as districts and counties. For these banks, the question is not if they will bear some of the pain, but how much, since they may need to restructure loans and raise provisions.

Is this debt swap program a credit positive for the LGFVs?

Investor view (Eric Liu, BlackRock):  The debt-swap program and loan restructurings are credit positives for LGFV bonds in the short term, but whether this is true over the medium to long term depends on two questions. First, is there a "holistic" plan to resolve the local debt problem? Second, can the central government control local governments' debt growth over time?

Localities' ability to support their LGFVs is weakened by the double hit of lower land sales and the absorption of some LGFV debts on their balance sheets. However, governments' willingness to support their LGFVs remains strong.

What is the one takeaway from your on-the-ground visits this year?

Real estate (Lawrence Lu):  There is a clear divergence between the higher-tier cities and the lower-tier cities. You can see that across the malls and the projects. There is also a big difference in foot traffic between projects of the financially sound, state-owned developers vs. the weak, privately owned players.

There were long lines outside restaurants across most cities, confirming that many consumer businesses are doing well, in contrast to the doldrums apparent in the showrooms of many property developers.

Investor view (Eric Liu, BlackRock):  The local governments and the LGFVs used to work independently to deal with their debt problems. Now they are working together--and with Beijing--to address the underlying structural issues.

LGFVs (Laura Li):  Key stakeholders are still trying to find a sure-fire way to resolve LGFV debt problems, but it has been difficult to arrive at an ultimate solution. During the pandemic, localities incurred even more debt, so it's more difficult now to tackle debt issues among their LGFVs.

Banks (Ryan Tsang):  Chinese banks are well-aware of the property sector, local government, and LGFV risks, but they also have to answer central and local calls on the policy front. The large banks seem well prepared for this balancing act and should be able to serve their mandates while protecting their credit profiles and limiting systemic risks.

Related Research

• China Tier-Two Local Government Risk Indicators Chartbook, Dec. 4, 2023
• Credit FAQ: Can China's 'Basket Of Measures' Defuse LGFV Debt Risks? Nov. 21, 2023
• China's Fiscal Bid To Stanch Local SOE Debt Risk, Nov. 2, 2023
• Overaggressive Borrowing Is Backfiring For More Of China's LGFVs, Oct. 30, 2023
• LGFV Strains May Inflict A RMB2 Trillion Hit On China Regional Banks, Oct. 18, 2023
• China Property Watch: A Slow, Sequential Recovery In 2024, Oct. 16, 2023
• China Still Has More Policy Tools To Stabilize The Higher Tier Property Markets, Sept. 26, 2023
• China Policy Patches Alone Won't Fix LGFVs' Fraying Liquidity, Sept. 7, 2023