China’s Looming Fiscal Abyss: Why Cities Face a ‘Cliff’ Despite Calls for Increased Spending

Hi, this is Anniek, writing to you from Singapore, with Evelyn, who reported from the Bund Summit in Shanghai last week. Welcome to the latest edition of The China Connection — a snapshot of what we are seeing and hearing from China watchers inside and outside the country.

Everyone wants China to spend more. So why is its government spending less, and what happens if the most indebted cities can't afford it anymore?

China's 'Fiscal Cliff' Threatens Economic Stability

While Western nations like the U.S. and Europe are being pressured to curb their burgeoning national debts, a paradoxical call is emerging for Beijing: spend more. At recent International Monetary Fund (IMF) and World Bank meetings in Bangkok, IMF Managing Director Kristalina Georgieva labeled the U.S. and European countries as the primary culprits of debt accumulation, asserting that "China needs to spend more, the U.S. has to save more, and Europe has to invest more."

Georgieva's plea comes as China's economy flirts with deflation, with growth projections slowing to 4.5% this year from 5% last year, and a further dip to 4% expected in 2027. Despite Beijing's comparatively lower official government debt, standing at approximately 68.4% of GDP, a deeper crisis lurks off-balance sheet. The augmented government debt, which includes local government financing vehicles (LGFVs) and other hidden borrowing, ballooned to an estimated 126.6% of GDP last year, a figure comparable to developed economies.

For decades, local authorities fueled rapid urban development by selling land to property developers. This crucial revenue stream has plummeted by more than half since the property market slump began in 2021, falling from 8.7 trillion yuan to 4.2 trillion yuan (approximately $590 billion), according to Beijing think tank CF40. In response, Beijing has moved to restrict new hidden debt, effectively shutting off a major engine of growth for local governments.

This squeeze has translated directly into reduced public spending. Nomura's chief China economist, Ting Lu, estimates that combined fiscal spending declined by 3.5% in the first eight months of this year, a stark reversal from last year's 3.6% growth. Lu aptly describes this as a "true fiscal cliff" that is significantly dragging on the economy. Urban fixed-asset investment, a traditional growth driver, saw its first decline in decades last year, falling 3.8%, and has steepened its descent to 7.2% in the first three quarters of the current year.

Despite these challenges, Beijing has maintained its official deficit target at around 4% of GDP, a figure that the Institute of International Finance believes is insufficient, estimating the actual deficit could reach as high as 9%.

Beijing has mandated that state-backed borrowers clear their hidden debts and transition into market-oriented commercial state-owned enterprises by mid-2027. While S&P Global Ratings reports that hidden debt in these vehicles shrank to 6.5 trillion yuan ($973.3 billion) last year from 14.3 trillion yuan in 2023, many still lack the necessary cash flow to service their interest payments and remain burdened by unprofitable public projects.

The IMF advocates for a medium-term fiscal framework that would allow China to expand fiscally in the near term to reflate its economy, while gradually scaling back support to ensure long-term debt sustainability. Furthermore, the fund urges China to abandon rigid growth targets, arguing that they incentivized local officials to over-invest, leading to resource misallocation and escalating provincial debt.

The stakes are incredibly high. Logan Wright, a partner at Rhodium Group, warns that allowing any local government to default could establish a dangerous precedent. However, local officials might paradoxically desire a bailout, knowing that Beijing would likely intervene once a default occurs, potentially running counter to the central government's efforts to instill fiscal discipline.

Need to Know

• Volvo Cars CEO Says China Sales Slump Came 'Faster Than We Thought': The Swedish automaker attributed a weaker third quarter to "tougher" market conditions in China and the U.S. CEO Håkan Samuelsson noted that Chinese consumers are increasingly favoring domestic brands, prompting Volvo to pivot its business strategy toward "regionally adapted cars." Read more
• House Committee Says Webull Messages Show China-Based Staff Could Access U.S. Customer Data: The House Select Committee on the Chinese Communist Party revealed that internal Webull messages suggest employees in China might have accessed sensitive U.S. user data, despite the online brokerage's assurances that such access was restricted to U.S.-based staff. The panel warned that this raises significant national security risks for American finance. Read more
• Wealthy Chinese Rattled by Beijing's Widening Tax Hunt Turn to the U.S.: Following Beijing's imposition of retroactive levies on offshore trusts in July, affluent Chinese individuals are consulting lawyers and bankers about opening U.S. bank accounts and relocating offshore assets. However, legal experts caution that the financial trail of funds leaving CRS jurisdictions could still expose clients to retrospective taxation. Read more

Coming Up

• Oct. 26 - 29: China's Communist Party holds fifth plenary meeting
• Oct. 27: China's industrial profits YTD
• Oct. 31: China's official manufacturing PMI for October
• Nov. 2: RatingDog manufacturing PMI for October

For more insights from The China Connection:

China industrial profits post strongest growth in three months as tech boom widens economic divide

China’s local governments are saving more, but fear is keeping them from spending: Eurasia Group

China's consumer slump demands a Japan-style stimulus response: Alpine Macro

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