The Chinese property development industry is in deep trouble. Investors in bonds issued by property developers are currently pricing in over USD 130bn in losses, with 70% of these bonds entering “distressed” territory. Together with widespread refusal among homebuyers to pay mortgages for unbuilt properties, many developers are on the brink of default. Beyond the obvious economic impact of the looming collapse of an industry that accounts for 30% of GDP, a quirk of local government finance means this situation has far broader implications for the Chinese economy, placing many local governments at risk of being unable to provide basic social services.

For years, local government budgets have been propped up by out-of-control development. At least 20% of local government revenue comes from “land concessions”, payments made to local governments in exchange for land. Local governments also use unsold land as collateral for bank financing. As property developers have stopped initiating new projects, land purchases and values have both decreased. Land revenues are down 55% compared to last year, with smaller cities being particularly hard-hit. Local governments also struggle to obtain financing as their primary collateral source has depreciated.

This collapse in revenue generation and credit access has already imperilled budgets, and local governments across China may default on their debts. Particularly in smaller municipalities, whose tax bases have already decreased due to migration towards major cities and zero-Covid disruptions, shrinking budgets may destabilize the provisioning of crucial services, including healthcare and transport. The question is now whether the central government is willing or able to bail out struggling municipalities, cutting against its deleveraging agenda and perpetuating moral hazard, or risk economic threats to social stability. With the Communist Party’s National Congress mere months away, the government must resolve this dilemma to have a chance of resolving the worst financial crisis in modern Chinese history.

This article first appeared in Axco' Flashpoints newsletter, which provides monthly analysis on country risk and geopolitics from our Global Risk team. You can sign up here