Yao Yang on China's Era of "Correction" (Part 2)

"I believe one reason scholars are so often looked down upon today is that many have lost their independence — they spend their time acting as cheerleaders for the government." — Yao Yang

This is our second instalment of Yao Yang’s candid assessment of the state of China’s economy and the measures needed to fix its problems.

In part one, Yao struck a relatively optimistic note, pointing to modest but perceptible signs of loosening constraints in China’s economy and society—albeit within a continuing era of policy “correction” and cut-throat economic competition.

Here, he turns to the more intractable challenges: weak demand, the collapse of the property sector and the crisis in local government finance—warning that, unless the central government rises to the occasion, China risks a Japan-style “two lost decades”.

— James Farquharson

Key Points

1. Scholars are held in low regard because they act as “cheerleaders for the government” instead of confronting genuine problems. Their reluctance to acknowledge the central importance of China’s real estate sector is telling.

2. The fact is, local government spending and real estate represent around 50 per cent of total demand in China. Failure to address these sectors risks entrenching deflation and ushering in a Japan-style “two lost decades”.

3. Although the central government has already embarked on substantial fiscal loosening, overlooking these two issues while focusing instead on boosting small-scale consumer spending would be missing the bigger picture.

4. The collapse in economic expectations is most closely tied to falling property values; if housing prices can be stabilised, other forms of big-ticket consumption will follow.

5. Undermined by the collapse in land sales (itself closely linked to the property sector) and still reeling from the fiscal impact of expenditure on Covid controls, local governments lack the resources to acquire housing stock and stabilise the sector.

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6. Although credit channels have been extended to local governments for the purchase of housing stock, the ongoing decline in prices removes any logical incentive for them to intervene in the sector.

7. As such, the responsibility for stabilising property prices rests with the central government, which should establish a “national team” to acquire mortgaged properties from households at a fair price.

8. The problem of local government insolvency can only be resolved by raising tax revenues to levels comparable with other upper-middle-income countries—including contributions from lower-income groups.

9. In the current situation, local governments are turning to non-tax revenues such as excessive fines, which only exacerbate weak demand and add pressure on businesses.

10. The central government should expand direct central bond issuance and use the proceeds to bail out local governments; in a deflationary environment, it can afford to borrow more.

The Scholar

Name: Yao Yang (姚洋)
Age: 60 (Nov. 1964)
Position: Dean and Professor, Dishui Lake Advanced Finance Institute, Shanghai University of Finance and Economics
Formerly: Dean of the National School of Development, Peking University (Nov. 2012 – Jan. 2024)
Research focus: China’s political economy, political philosophy and economic development
Education: BA Peking University (1986); MA Peking University (1989); PhD University of Wisconsin-Madison (1996)

YAO YANG: CHINA’S POLITICAL AND ECONOMIC SITUATION IN THE CONTEXT OF OUR ERA’S NARRATIVE | JIABIN FRONTLINE CLASSROOM
Yao Yang (姚洋）
Published by Jiabin Business School on 11 September
Translated by Jan Brughmans
(Illustration by OpenAI’s DALL·E 3)

1. The Wrong Way to Boost Consumption

So, how do we move forward?

This year, the government has indeed taken a series of notable measures. It has set a growth target of around 5 per cent, signalling its intention to sustain steady momentum. To bolster demand, it is providing 300 billion yuan in government subsidies [国补资金]—once delivered through “trade-in” schemes [以旧换新], but now offered as direct support. Monetary policy also remains accommodative, with several rounds of interest rate reductions already in place. On the fiscal side, expansion has reached unprecedented levels: central and local on-balance-sheet debt has risen by 12 trillion yuan. Meanwhile, the central government’s deficit ratio has increased to 4 per cent—fully one percentage point above the long-standing 3 per cent ceiling.

Local governments have issued 4.4 trillion yuan in special bonds, and here there is a major breakthrough: these bonds can now be used for the “Three Guarantees” [Note: 三保, namely: ensuring basic livelihoods, salaries, and normal government operations]. Normally, special bonds are not counted as part of the government deficit because they are earmarked for investment projects expected to generate returns. This time, however, they have been authorised to fund the “Three Guarantees”—in other words, to bail out local governments by supplementing their operating budgets. They may also be used for land and housing purchases. This demonstrates that Beijing recognises the property downturn cannot be allowed to continue unchecked, and is calling on local governments to absorb excess housing and land.

But these measures have not produced the desired results. Why? In my view, concentrating solely on households and personal consumption is misguided—it points in the wrong direction. It is like picking up sesame seeds while losing a watermelon [捡了芝麻，丢了西瓜]. Why do I say this? Because consumption is a lagging indicator [慢变量].

This is the breakdown of GDP by expenditure: consumption, investment, and net exports [Note: the graph to which Yao Yang is referring is unavailable]. The sharpest decline in consumption occurred in the first decade of this century, when its share fell from over 60 per cent to below 50 per cent—a drop of 14 percentage points in just ten years, an exceptionally rapid pace. Why? The reason is straightforward: during those years exports grew at breakneck speed. From 2001 to 2008, in only seven years, exports increased fivefold. Such a surge meant that we were essentially producing for other countries. The vast earnings were converted into savings, while consumption lagged behind.

After 2010, however, a turning point emerged: the consumption rate actually began to rise. Why did it later flatten out, and even edge down slightly? The answer lies in the pandemic. During COVID, expectations deteriorated and opportunities for consumption disappeared, so the rate declined. Yet over the past two years it has begun to climb once again.

Consumption is a lagging indicator. One cannot expect its share in GDP to rise by two or three percentage points within a single year. Even an increase of 0.8 points is already a strong outcome. Slow and steady [慢慢来].

Consumption depends on two factors: income growth and expectations. In fact, income growth has remained relatively strong; the real issue, however, is expectations. When people feel pessimistic about the future, they simply stop spending. So, what should we do in this situation? Should we attempt to boost consumption with token measures [小打小闹]—such as the 300 billion yuan in subsidies—or should we focus our efforts elsewhere? I believe our attention should be directed towards the two elephants in the room: real estate and local government finance.

2. The Elephant in the Room: Real Estate is Still the Largest Industry

I believe one reason scholars are so often looked down upon today is that many have lost their independence—they spend their time acting as cheerleaders for the government. In my view, the first duty of a scholar is sincerity [真诚]: you must believe in your own research. If you do not even trust your own findings, and instead spout nonsense, then you are no scholar at all. What I have just shared with you is what I truly believe. On the question of how correction should be carried out, I do hold a different opinion—and that is what I want to discuss next. Real estate must be corrected, but not in the way it is being managed at present. That said, I agree with the overall direction, because my own research tells me it is the right one.

Real estate remains our largest industry. Some people, keen to prove that government policy is correct, claim that the ICT sector has already overtaken it. Yet ICT spans so many different industries that aggregating it and declaring it the largest sector is meaningless. Real estate is still the biggest. I estimate it continues to account for at least 6–7 per cent of GDP directly, and once upstream and downstream linkages are included, the figure rises to more than 10 per cent—perhaps as much as 13 or 14 per cent. It is vast, and, moreover, it is closely bound up with consumption.

If you look around the market today, you will see plenty of eating and drinking. Train stations are crowded, and even Terminal 3 at Beijing Capital Airport is overflowing with people. At first glance, you might think consumption has already recovered. But if that is the case, why do the official consumption figures still appear weak?

The reason is that big-ticket consumption [大宗消费] has collapsed. People have stopped buying homes. And once home purchases stop, so does renovation. In a second-tier city, fitting out an apartment with household appliances and decoration costs at least 300,000 yuan. For people like you, doing up a home can easily run into the millions. By contrast, do you think you can consume a million yuan just through eating and drinking?

I estimate that property-related demand still accounts for around 15 per cent of final demand.

How much of our total demand comes from local government? Around 35 per cent. So if you add local government and real estate together, they account for about half of overall demand. To ignore these two sectors and instead go around picking up sesame seeds [满地去找芝麻], hoping to lift the consumption of 1.4 billion people, is a case of working twice as hard for half the result [事倍功半]. But if we focus on real estate and local government, then it is half the effort for double the result [事半功倍].

Since its peak in 2021, China’s real estate sector has been in decline. The “three red lines” policy cut it down in one stroke, and since then it has never returned to positive growth. On the right-hand side you can see a Goldman Sachs simulation: the darkest line represents China’s downturn, the middle line Japan’s, and the lightest line the United States’ [Note: We were unable to find this graph]. US policy was comparatively well targeted, so after a brief dip its market quickly recovered. But even by the American standard, we still face another three or four years of decline. And if the trajectory follows Japan’s, it could result in a “lost two decades”.

3. To Avoid a “Two Lost Decades”, First Fix the Property Sector

The central government has also recognised the problem, which is why it continues to stress the need to stabilise real estate. But how exactly should that be achieved? Take, for instance, the lifting of purchase restrictions. This has had little effect—the public response has been fleeting, essentially just a weekend blip. Then there is the expansion of the “white list”. Do you know how the white list system [“白名单“制度] works? Real estate firms are classified by project: if a project makes the list, it can access bank loans; if it does not, then no financing is available. As a result, many genuinely solid property developers have been pushed into collapse. One project defaults, and the entire company goes under. Now that the property sector has returned to more normal conditions, why can banks not simply be allowed to decide for themselves which companies they will lend to?

Next comes housing buybacks [房屋收储]. How was this supposed to work? The first attempt saw the central bank provide 300 billion yuan in relending, which, once amplified through the banks, amounted to about 500 billion. The plan was for local state-owned enterprises to borrow from banks and then buy up land and housing. But those so-called local SOEs were really just local government financing vehicles. And these LGFVs are already drowning in debt—year after year they raise perhaps three to five trillion yuan, but 90 per cent of it is simply new borrowing to repay old loans. Could anyone seriously expect them to take on fresh debt to buy up property? Impossible.

So came the second plan: 4.4 trillion yuan, with local governments themselves stepping in. No need to borrow from banks—local government bonds, especially special bonds, could be used to purchase housing. But local governments have been reluctant. Why? Because their officials know the state of the property market as well as we do: prices are still falling. To ask them to use local debt to scoop up these homes is simply irrational.

So what should be done? I believe we should take a lesson from our stock market. There, we created a “national team” [国家队] to step in and buy shares directly. Once the national team enters, it is committed to keeping the market steady, turning it into a slow bull [慢牛]. If prices rise too quickly, the national team sells, ensuring it never turns into a mad bull [疯牛].

But as we all know, the stock market has little to do with the Chinese economy. Even at its peak, annual fundraising through the stock market was just over 600 billion yuan, while total social financing runs at the 30-trillion level. Real estate, by contrast, is far more important to the real economy. So if we have had the resolve to deploy a national team to intervene in the stock market, why not form a national team to intervene in the housing market? The housing sector is in far worse shape. Judicial foreclosures alone are enough to drag the entire market down. Last year there were 750,000 foreclosure cases; this year the number will reach one million. And this is not an abstract figure—it means one million families will lose their homes this year. Foreclosed properties are auctioned at barely half of normal market prices. Yet even then, only 10 per cent can actually be sold. With foreclosures flooding the market, stabilising property prices is simply impossible.

We should form a national team and begin by buying up these foreclosed homes. How might this work in practice? Take a household that can no longer repay its mortgage. Instead of sending the property to foreclosure, the bank could transfer it to a newly established agency—let us call it a Central Housing Reserve [中储房]. This agency would purchase the home at a fair and reasonable price. We cannot allow everything to be sold off at half price through foreclosure, because if homes are only bought at those levels, prices will never recover. By acquiring them at fair value, we can stabilise the market.

And what happens next? First, the original owner could be asked if they wish to rent the home back. If they do, it should be rented to them at a relatively low rate, effectively turning it into a form of affordable or public rental housing. Later, when the economy improves, the property could be sold again—perhaps the Central Housing Reserve might even make a profit, with the original owner opting to buy their home back.

The United States has experience with this. During the financial crisis, the US government intervened directly with capital injections—and three or four years later, it suddenly found it had made money. If the central government truly has confidence in China’s economy, then it should be bold enough to put its money where its mouth is [敢于把钱放在桌子上] and buy up the property stock. I believe housing prices would then recover. Once ordinary people see that the central government itself has that determination, they will start buying homes again.

Some may worry: would this not risk another frenzy in the property market? I do not think so. After the lessons of this cycle, the public will be more rational. China’s housing market cannot return to the wild surges of the past—it will instead settle into a more normal pattern.

4. China’s Chronically Low Taxation

Local government finance is an even bigger problem. Many local governments are now running huge structural deficits in their regular budgets. And here I am not even referring to their off-balance-sheet debt—the 60 to 100 trillion yuan of it. Let us leave that aside. I am talking only about their on-balance-sheet hidden liabilities [隐性债务]. How large are these? Professor Bai Chong’en of Tsinghua’s School of Economics and Management estimates 4.2 trillion yuan. Professor Li Daokui puts the figure at 6 trillion. Market estimates are usually around 10 trillion.

This includes the money local governments owe to enterprises—and I suspect many entrepreneurs in this room are among those still waiting for the government to pay what it owes you. Yet it remains uncollectable [收不回来].

So, what is the reason? First, tax cuts. In terms of both overt and hidden reductions, we have simply cut too much over the past decade or so. Now, some of you in this room may not like me saying this, but China’s tax burden is far too low. Our tax revenue amounts to only 14 per cent of GDP. How low is that? It has fallen back to the level of 1994, at the time of the tax-assignment system reforms [Note: The tax-assignment system (分税制) reforms under Premier Zhu Rongji rationalised the share of tax revenues between the centre and local governments, stabilising the fiscal base but creating a long-term gap in local government finance—largely filled by land sales and LGFVs]. That is a dangerously low level. No upper-middle-income country runs on so little—most are above 20 per cent. In the United States, the figure is over 30 per cent. So do not complain that China’s taxes are high—they are in fact far too low.

Of course, the burden should not fall entirely on businesses. Ordinary citizens must also pay more tax. Take property tax [房地产税]—it must be introduced, and it could well raise two or three trillion yuan. And, to be frank, we also need tighter enforcement of income tax [税收监管]. Do you know what share of our working population actually pays income tax? Only 14 per cent.

Some people simply have no idea how low our incomes really are. Take Ms Dong, for example, who suggested raising the income tax threshold to 10,000 yuan a month [Note: Referring to Dong Mingzhu (董明珠), chairman and president of Gree Electric and deputy to the National People’s Congress]. I told her: if you set it that high, fewer than 5 per cent of people would pay tax. This is pure “let them eat cake” thinking [Note:何不食肉糜, or “Why do they not eat meat porridge?”—attributed to a Jin dynasty emperor as his response to reports of famine; although Dong’s companies could expect to enjoy tax breaks, it is unrealistic to expect these benefits to be shared by the wider populace].

In the years ahead, tax rises are inevitable. Otherwise, there is no way forward—local governments simply cannot survive.

Second, land transfer revenues have collapsed. At their peak in 2021, they reached 8.7 trillion yuan. Last year they fell to only 3 trillion, and this year they will be around 2 trillion. And even much of that is fictitious—local governments selling land to their own companies, shuffling it around purely to make the GDP figures look better.

And of course, there was also the enormous expenditure on Covid controls. In most countries, this was borne mainly by the central government. But in China it fell largely to local governments—and their outlays were immense.

So, what has happened now? An unprecedented local fiscal crisis. Let me be clear: since the founding of the nation [建国], this has never happened before—local governments have run out of money. And when there is no money, what do they do? They ramp up non-tax revenues, such as “fishing in distant seas” [Note: 远洋捕捞, referring to local governments engaging in aggressive law enforcement through fines and penalties]. The economic impact is obvious: overall demand in society is weak, and private enterprises are under growing pressure.

5. The Need for Debt: Later Generations Can Pay

The impact is absolutely enormous. When local governments run out of money, it is not just their problem—it becomes an economy-wide problem, a problem for the whole of society. What should we do? The funds for the “Three Guarantees” are far too small. The central government has acknowledged the issue, but the measures taken so far are not strong enough.

I propose that over the next three years, we issue 4 trillion yuan in special central government bonds each year, count them in the central deficit, and use the proceeds to resolve local governments’ fiscal crisis. Unless this crisis is addressed, we will not be able to loosen the screws.

I will not even go into off-balance-sheet debt here. Let me just touch on leverage, because that is something many people discuss—including many of our entrepreneurs. You often hear it said that money in China is worthless, or that China may be facing inflation. But such views reflect a poor understanding of debt. People claim China’s debt ratio is high, that our M2 divided by GDP is over 300 per cent. But that perception is skewed.

Why is China’s M2 so large? The main reason is that we run a bank-dominated financial system. Ordinary people prefer to place their savings in banks, and enterprises do the same. Banks, in turn, operate a credit expansion mechanism. Modern commercial banks automatically create money [Note: In the process of lending out money, creating a bank deposit—which increases M2].

In the United States, it is the other way round. Around 70 per cent of financing is direct, bypassing the banking system—so it does not show up through the same multiplier. But if you add up all the messy layers of US debt in the market, especially derivatives, the total runs into the hundreds of trillions of dollars. So tell me: where is the real financial risk greater—in China, or in America?

Chinese people do not like taking on debt. In fact, we are especially afraid of it. When times are hard, how do ordinary families get through? They tighten their belts and endure. Our enterprises do the same: when conditions are tough, they cut back and struggle through. At the micro level, that behaviour makes sense. But at the national level, it is the wrong approach. One of Keynes’s great insights was precisely this—what he called the “paradox of thrift”. For an individual or a household, thrift is a virtue. But at the scale of an entire country, when the state also insists on thrift, it becomes a mistake.

So, when everyone else is tightening their belts, the government must do the opposite—it must spend—because businesses do not want to take on more leverage, and households are deleveraging as well. People are repaying more than they borrow, which means they are automatically reducing their debt.

Just look at the numbers: in 2023, new household savings reached 16.6 trillion yuan; in 2024, 14.2 trillion. And in just the first half of this year, they have already reached 10.7 trillion—implying that for the full year the figure will exceed 20 trillion. So, is it that ordinary people have no money? No—the money is there. But it is locked up in savings, not circulating in the economy.

Hence, the only solution is for the government to take on more leverage. In our current situation of excess capacity [产能过剩], there is no risk of runaway inflation. Inflation is a relative concept—do not assume that just because the government spends, inflation must inevitably follow.

And where does government money actually come from? Let us clear up a common misconception. Many people think government spending means “printing money”. That may be true in the United States—when the US government runs out of money, the Federal Reserve has to “print” it. But China does not need to do that. Who does our government borrow from? From the banks. And where do banks’ funds come from? From household deposits, from enterprise deposits.

In other words, the government is effectively borrowing from households and firms, and spending on their behalf—because they themselves are unwilling to spend. This is what is meant by trading space for time: in the future, we shall be spending again.

Then, who pays the debt? Our children and grandchildren will. One of the great strengths—and also a weakness—of the Chinese people is that we think in the very long term. We live not for ourselves but for our descendants. For individuals, that may be rational; but at the level of the state, it becomes irrational. And in fact, asking future generations to shoulder the debt has two advantages. First, intergenerational fairness. Why should my granddaughter, simply because she is born sixty years later, live with a silver spoon in her mouth [含着金汤匙]? That makes no sense. Second, future Chinese will be far richer than we are. What looks today like a terrifying 100 trillion yuan of debt may, twenty years from now, seem nothing extraordinary.

That is why the central government must spend more now. Its top priority must be to rescue local governments.

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