China's Mounting Debt Crisis. What's Next?

President Xi Jinping has unveiled ambitious plans to overhaul China’s financial system in response to the mounting debt crisis faced by local governments. The measures outlined in a comprehensive resolution published by the official Xinhua News Agency focus on reallocating revenue from the central government to local authorities. This includes granting regional governments a larger share of consumption tax revenues, aiming to alleviate their financial burdens. This reform is considered the third significant shift in taxation and fiscal policy, following previous major changes in 1994 and 2013 that adjusted the balance of revenue and allowed localities to issue bonds independently.

Ding Shuang, chief economist for Greater China and North Asia at Standard Chartered Plc, noted that these reforms are intended to rectify an imbalance between central and local government finances that was established under former President Jiang Zemin. The objective is to reduce the disparity between spending responsibilities and income, thus easing the fiscal pressure on local governments.

The yuan's value remained relatively stable in early trading as investors assessed the implications of the plenum's statements and a surprise cut to short-term interest rates. More detailed policies may be disclosed later this month by the Politburo, which will focus on economic strategies for the year.

The Fourth Plenary Session, presided over by Xi Jinping, was the first major reform meeting since his unprecedented third term in office. The session saw the endorsement of Xi’s long-term vision for China’s economic future, which includes a continued emphasis on state control over the economy and a move away from volatile debt cycles. This vision was reaffirmed, with no significant deviations from his established plans.

Xi’s previous use of the Third Plenary Session in 2013 aimed at injecting a more decisive role for markets, raising hopes for liberal economic reforms. However, Xi's recent focus on increasing state control and reducing reliance on debt cycles remains consistent. Alicia Garcia Herrero, Chief Economist Asia Pacific at Natixis, pointed out that Xi's agenda prioritizes technological self-reliance and economic independence from the US, underscoring his commitment to reshaping China’s economic landscape.

The resolution from the Third Plenary Session reflects Xi’s ongoing commitment to addressing risks and fine-tuning policies. The central government faces pressure to manage local governments' staggering 66 trillion yuan ($9.1 trillion) in hidden debt and to rebalance the economy. By allocating a larger share of consumption tax to regional governments, the policy aims to stimulate consumer spending and provide new financial resources.

Key highlights of the resolution include the establishment of a housing system that encourages both renting and purchasing, giving cities greater control over real estate regulation, and allowing markets to play a more decisive role in resource allocation. It also proposes raising the retirement age gradually in a flexible manner and implementing regulations to control wealth accumulation and executives’ wages at state-owned firms. Additionally, the policy aims to open up infrastructure and technology sectors to private firms and improve their access to financing.

Despite these broad plans, specific details on policy implementation were lacking. Imposing additional taxes on goods could further dampen consumer sentiment, particularly given the ongoing property slump affecting household wealth. Recent data showed the slowest retail sales growth since December 2022, and second-quarter economic figures fell short of expectations.

The resolution also indicates a stronger focus on national security, with plans to enhance surveillance and establish a unified population management mechanism. Xi’s emphasis on high-quality development, which involves advancing technology and reducing reliance on foreign tech, remains a central theme. This includes promoting sectors such as artificial intelligence, new materials, and quantum technology, and developing self-sufficient supply chains for integrated circuits and advanced materials.

The Third Plenary Session did not introduce any major new measures but reinforced the existing policy direction. This approach reflects a preference for long-term structural changes over immediate economic stimuli. Critics argue that the lack of short-term stimulus measures could hinder a faster economic recovery, highlighting a potential misalignment between current policy actions and the immediate needs of the Chinese economy.

The reluctance to provide fiscal stimulus or rescue the struggling property sector indicates a belief that these measures might counteract the progress made in addressing economic imbalances and debt issues. Although the economy continues to grow and export performance remains positive, domestic demand remains weak, which poses a risk of prolonged stagnation.

Policymakers face challenges in managing the shift toward high-tech industries and ensuring that state-led industrial policies effectively adapt to market changes. The current approach, which heavily relies on top-down directives, may struggle to address the complexities of the modern economy and could lead to unintended consequences, such as weak investor confidence and reduced consumer spending.

​Overall, the Third Plenary Session underscores the Chinese leadership’s commitment to long-term economic reforms and technological self-sufficiency, while grappling with the immediate challenges of economic slowdowns and debt management.