- Is China's explosive growth model—built on a cyclical relationship between its real estate market, finance, and economy—finally on the verge of collapse?
- Is China's banking system truly “too big to fail”? How did this financial monster come to be?
- If the banking industry were to significantly shrink its balance sheet, how would this impact China's financial internationalization strategy?
China's financial system has experienced astonishing growth in the last few decades. Its total asset scale has already become an influential force in the global financial landscape. Since 2012, China's four largest state-owned banks (Industrial and Commercial Bank of China, China Construction Bank, Agricultural Bank of China, and Bank of China) have steadily maintained their rankings as the world's top banks by assets, and their total assets continue to grow. (See below graph)
China's banks quickly expand to be the world's top four
Reasons for this include:
1. Sustained economic growth and globalization: China has experienced rapid economic development, including a trade surplus resulting from its status as “the world's factory.” This has allowed China to quickly accumulate capital, enabling the banking system to expand its lending business.
2. Rise of the housing market: Since the 2000s, the housing industry has become the main force behind China's economic growth.The financial industry has also expanded, with banks providing a large number of mortgage and development loans.
3. Government policy: To support infrastructure and industrial development, the Chinese government provides a large amount of credit through its banking system. Overseas investments such as the Belt and Road Initiative have also contributed to bank asset growth.
4. Increased deposits and liquidity: China's high household savings rate has led to a continuous rise in bank deposits, providing a large amount of loanable funds and contributing to the ongoing expansion of bank balance sheets.
The capital growth of China's banking industry primarily comes from increases in deposits, and the rate of deposit growth is closely tied to the economic environment. As economic growth declines and unemployment rates rise, the growth of corporate and household deposits has slowed over the past two years and impacted bank liquidity. (See below graph)
Additionally, China's real estate market has gradually cooled since 2021, increasing the risk of non-performing loans and further curtailing the expansion of bank balance sheets.
Local government finances and real estate development are closely linked
The primary drivers of bank asset expansion are the increase in deposits fueled by China's economic growth and long-term credit support for the real estate industry. The latter encompasses not only home purchase loans (i.e. mortgages) but also construction loans, development loans, and various infrastructure credit instruments led by local government land financing vehicles. When housing prices rise, these lending activities are both safe and highly profitable. High collateral values, low default rates, and relatively conservative risk weighted assets allow banks to continuously expand their assets and earnings.
Furthermore, local governments themselves have become a significant source of bank assets, using land finance to integrate land transfer revenue with financing vehicle debt. They then rely on banks for support, creating a closed loop of local finance, land, and bank credit. Banks function as both providers of capital and policy facilitators for regional development.
The above graph shows commercial bank credit data published quarterly by the People's Bank of China, particularly loans granted to the real estate sector. Prior to 2020, annual growth rates for residential mortgage loans, real estate development investment, and overall real estate credit lending exceeded 10%. In 2016–17, the growth rate for residential mortgage loans exceeded 30%. These large-scale credit injections, along with numerous residential towers built in China (some of which were left unfinished), became a key factor in the expansion of commercial bank assets.
Infrastructure projects involve huge investments and long payback periods, with some lacking sufficient passenger traffic and economic benefits. However, local governments continue to borrow heavily as they anticipate incoming financial support from the central government, leading to accumulated debt risks. Statistical data shows that government bonds accounted for 48% of total social financing in 2023, indicating that a large amount of bank funds are flowing to local governments rather than corporations.
The Chinese government has responded, particularly since the second half of 2015, to the rapid growth of housing prices in major cities, with Xi Jinping touting the phrase “housing is for living, not for speculation.” The government has also introduced various stringent real estate control policies. For example, its “three red lines” policy aimed to curb financial leveraging of real estate developers, thereby reducing bank lending to real estate developers and impacting growth of banking assets.
As a result, real estate developers turned to shadow bank institutions like local financing vehicles for funding. Banks then fulfilled their intermediary role by selling wealth management products, many of which are non-financial bonds or municipal investment bonds issued by local financing vehicles. If the development projects are successfully completed and converted into residential mortgages, repayment comes from these mortgages, bringing shadow banking claims back into the bank's lending system.
The state advances as the private sector retreats
As the Chinese government increasingly intervenes in the economy, its relationship with state-owned banks also becomes more entangled, particularly in financial market regulation and credit policy. The government strengthens the capital structure of state-owned banks through direct capital injections, low-cost liquidity provisions, and issuance of government bonds. In 2024, the Chinese government issued 3 trillion renminbi in special government bonds, part of which was used to inject capital into state-owned banks to replenish their core capital. Although this method gives the financial system short-term stability, it further ties state-owned banks to government finances, making banks increasingly dependent on government funding, rather than market mechanisms, to maintain stability. Additionally, as the influence of state-owned banks grows, more private banks are squeezed out.
At the same time, the government's regulatory policies provide more protection for state-owned banks, reducing the risk-bearing capacity of private banks. Some have even been forced to exit the market. In 2024, the government deregistered 199 small and medium-sized banks, surpassing the number deregistered from 2021 to 2023. This indicates that integration within China's financial industry has further accelerated. State-owned banks gradually expand their market share, while small and medium-sized banks, especially private banks, face a survival crisis.
Another significant change is the allocation of credit resources. Under the policy of “the state advances as the private sector retreats,” state-owned banks tend to focus lending resources on state-owned enterprises rather than private enterprises. This causes an imbalance in the allocation of market resources, making it difficult for some private enterprises to obtain sufficient financing to remain competitive. With funding chains disrupted, many private enterprises are at risk of bankruptcy, while state-owned enterprises with less efficient capital management, continue operating thanks to government support.
Moreover, state-owned banks that hold large amounts of debt from state-owned enterprises are at higher risk of non-performing loans. If the economic environment continues to worsen, these banks could become “zombie banks” and require even greater reliance on government support to maintain operations.
In short, China's policy of “the state advances as the private sector retreats” altered the competitive landscape of the banking industry, strengthening the dominant position of state-owned banks while posing serious challenges to the development of private banks. Directing credit resources to state-owned enterprises may lead to a decline in the efficiency of market resource allocation, thereby impacting long-term economic development.
China's soft budget constraints increase risks
The term “soft budget constraint” was coined by Hungarian economist János Kornai and originally referred to a feature of planned economies where businesses could rely on state support when facing capital shortages, resulting in a lack of self-regulatory financial discipline. This phenomenon is still present in China's financial system and has been further exacerbated through capital flows and government-led credit expansion.
China's soft budget constraints are not like the direct fiscal gains of the former Soviet Union, but rather more complex forms of indirect financing disguised as market-oriented support. The most representative example is excessive debt-raising in the real estate market by local government financing vehicles (LGFV) and large developers.
Take local governments, for example. Many companies are suffering from long-term losses and are heavily indebted, yet banks continue to lend credit because of implicit guarantees that local governments will provide support. Although the central government has repeatedly emphasized the need to prevent local debt risks, local and regional governments continue to use various policy tools and institutional designs to maintain funding for these local financing platforms, thereby weakening the financial institutions' ability to respond to risks.
This institutional tolerance is also reflected in banks' financial reporting practices. Faced with obvious default risks, financial institutions often resort to methods like rollovers, restructuring, and using new loans to repay old debts to maintain the appearance of asset stability. This not only conceals the true extent of bad debts but also prevents the flow of funding to productive and innovative sectors, supporting inefficient production instead.
The same logic applies to real estate development. Many small and medium-sized real estate companies rely on connections with local governments instead of strong operational capabilities to gain advantages in land auctions and financing approvals. In this model, soft budget constraints become entangled with corruption, effectively overriding market-based mechanisms for risk management, which would otherwise charge higher interest rates or even deny loans to high-risk investors. This allows politically favored firms to continue receiving funding despite facing bankruptcy.
This capital cycle transfers risk from individual market entities to the banking system, and then to local government finances, ultimately creating an institutional arrangement that prevents risks from erupting into full-blown crises. This explains why the bad debt ratio of China's banking industry has remained extremely low. It is not that there are no risks, rather they have not yet been revealed. As the Soviet Union experienced, once economic headwinds hit, the ensuing chain reaction will cause soft budget constraints to accelerate risk accumulation.
Real estate bubble triggers a wave of mergers among small and medium-sized banks
China's banking industry still experiences continued growth of total assets and liabilities. However, Reuters reported on February 12, 2025 that China is undergoing an unprecedented regional bank consolidation campaign. To date, nearly 300 rural banks and credit cooperatives have been integrated into large regional banks, with total assets reaching 57 trillion yuan (approximately US$7.8 trillion). This wave of consolidation is not only a major shift in the structure of local financial systems, but is also closely linked to China's worsening real estate crisis.
The report noted that many regional banks had been heavily lending to real estate-related companies and local financing platforms. Following a sharp drop in housing prices and a series of developer defaults, the quality of these banks' assets rapidly deteriorated. The non-performing loan ratio of rural commercial banks averaged 3% , significantly higher than the national average (approximately 1.5–1.7%), with some even reaching 20%. After the real estate bubble burst, these small local banks were the first to suffer.
For this reason, Chinese authorities have opted for large-scale mergers to address local financial risks, particularly non-performing loans, which highly correlate to the housing market. For example, in Liaoning Province, the newly established Liaoning Rural Commercial Bank absorbed 36 high-risk banks. While this temporarily stabilized market confidence, experts warn that consolidating numerous troubled banks without strengthening capital and governance structures could amplify systemic risks.
This wave of mergers demonstrates that the real estate crisis is no longer solely a developer problem, and is now spreading to the entire financial system due to pressure on local banks. China has chosen an administratively-driven approach to control the spread of risk, but its effectiveness and cost remain to be seen.
If banks reduce their balance sheets, China's international financial influence will weaken
Over the past decade, the Chinese government has been committed to increasing its international financial influence, accelerating the internationalization of renminbi through a number of strategic initiatives. The People's Bank of China has actively promoted the Cross-border Interbank Payment System (CIPS) and signed currency swap agreements with multiple central banks to establish a clearing system independent of the US dollar. Meanwhile, banks like the Bank of China and the Industrial and Commercial Bank of China have continued to expand their overseas presence, entering markets in Asia, the Middle East, Africa, and Europe. In support of the Belt and Road Initiative, policy-based financial institutions have provided a large amount of infrastructure loans and clearing services, creating a Chinese-version of an international financial network. These initiatives collectively form the institutional foundation for China's financial exports.
Let us consider Japan's situation in the 1990s. Japan became the world's second-largest economy during its asset price bubble period. However, its financial system rapidly contracted in the aftermath of the asset collapse. Banks were mired in non-performing loans, leading to reduced overseas portfolios, and causing Tokyo to gradually lose its position as Asia's financial center. Thus, once a price bubble bursts domestically, a country's financial system must prioritize eliminating risks and repairing capital by returning overvalued assets to their fair market value. The resulting reduction in asset value from such liquidations severely limits external resources and the ability to execute strategic objectives.
Therefore, a systemic collapse of China's real estate market would directly undermine the stability of bank balance sheets, forcing financial institutions to tighten external credit and investment. The overseas business and renminbi settlement capabilities of Chinese banks would simultaneously decline, disrupting their financial expansion into emerging markets. Renminbi would also lose international trust. While basic clearing systems like CIPS still exist, they could become mere formalities with no real sustained influence. Ultimately, China would face a major setback in their plan to establish a system independent of the US dollar.
Three points in observing systemic risks to China's financial system
Overall, the logic of soft budget constraints and policy-driven asset inflation has not fundamentally changed. However, China's seemingly controllable and stable financial system is actually highly vulnerable.
To assess the evolution of China's financial risks, several key indicators warrant close observation. First, will the frequent consolidation and failure of small and medium-sized banks continue to rise? Will there be a chain reaction of insolvencies among rural and regional financial institutions? Small banks will be the first exposed to risks related to real estate and local government debt.
Secondly, we must observe whether the non-performing loan ratio exceeds the official tolerance limit. Although China's bad debt data has long been suppressed by rollovers and reclassifications, if actual amortization and recognition of losses occurs, then risks can no longer be concealed.
Lastly, we must observe whether the central government has been forced to implement systemic financial restructuring, such as large-scale capital injections, the establishment of asset management companies (AMC), or the initiation of special debt-to-equity swaps. The emergence of these signals would mark a significant turning point, signaling the appearance of systemic risks.
The global rankings and asset size of China's banking system are truly impressive, but delving deeper into its asset sources and risk structure reveals the reality. This financial system is not purely market-driven, but policy-driven, and deeply rooted in real estate and local fiscal dependence. With the real estate system on the verge of collapse, China's financial system will ultimately face significant challenges if they do not enact radical reforms and rebuilding. Given China's unique resilience, it is difficult to predict whether the outcome will be a gradual orderly descent or a heavy painful crash.
（Translated by Nicole Wong）