China’s economic and financial risks and the prospect of reforms: An interview with David Daokui Li

Introduction

David Daokui Li is the Mansfield Freeman Chair Professor of Economics at the School of Economics and Management in Tsinghua University. He is also the Director of the Academic Center for Chinese Economic Practice and Thinking and the founding dean of the Schwarzman College at Tsinghua University. He also served as a member of the 11th and 12th National Committee of the Chinese People’s Political Consultative Conference. In addition, he has held several prominent positions, including Advisor for the Sino-German Economic Advisory Council, Member of the Global Agenda Council for the World Economic Forum in Davos, Vice President of the Chinese Society of World Economics, and Editorial Board Member for journals such as Economic Research and World Economy. He is also a Distinguished Research Fellow at the China Institute for Reform and Development and a Special Commentator for China Central Television. In the past, he has been a member of the Monetary Policy Committee of the People’s Bank of China, a consultant for the World Bank, and served as the President of the Chinese Economists Society (CES) from 2001 to 2002.

At the founding ceremony of the academic journal Risk Sciences, Professor Li gave a keynote speech on the current economic situation and the major risks faced by the Chinese economy. He emphasized the distinction between the immediate “firefighting” risks and the long-term systemic risks, as well as some feasible measures to address these challenges through comprehensive reform. In a follow-up, Li sits down with Runhuan Feng, the Editor-in-Chief of Risk Sciences, to discuss his key messages and suggestions for China’s policymakers.

Economic and financial risks

Question: What are the core risks that the Chinese economy is currently facing, and how do these risks influence the direction of future reforms?

Li: The Chinese economy is in a critical period of transformation, and the risks are multi-layered. Based on their nature, the risks can be categorized into two types: one type consists of “immediate fires” that need to be extinguished promptly, while the other involves systemic risks lurking beneath the surface.

The short-term “firefighting” risks are particularly pronounced within the financial sector, notably in the real estate market. In contrast, long-term systemic risks are frequently underestimated. Addressing these two categories of risks necessitates differentiated strategies; failure to do so could precipitate a chain reaction, undermining economic stability.

Immediate “firefighting” risks

Question: You have mentioned that the “firefighting” risks are particularly prominent in the financial sector, especially in the real estate industry. Could you elaborate on the specific manifestations and impacts of these risks?

Li: The short-term “firefighting” risks refer to those that require immediate attention and swift measures for mitigation. In the financial sector, especially after experiencing events like the 2008 global financial crisis and the 1997–1998 Asian financial crisis, we have seen the seriousness of such risks. Currently, a typical example is the financial risks faced by China’s real estate industry.

In August 2024, these risks began to crystallize within the real estate sector. The enthusiasm of homebuyers waned significantly, leading to a sharp decrease in mortgage balances. Consequently, the sales revenue of residential properties developed by Chinese real estate companies plummeted to 9.68 trillion yuan in 2024, reverting to figures seen back in 2015. Major developers such as Sunac, Vanke, and Country Garden faced intensified challenges, particularly in third- and fourth-tier cities, exacerbating overall market instability. This predicament not only jeopardizes the operations of developers but also has the potential to trigger a wider economic crisis.

Thus, it is imperative to address these financial risks swiftly to mitigate broader economic repercussions. However, the financial risks within the real estate market are often misinterpreted as a singular issue. This requires establishing an interdepartmental coordination mechanism and implementing timely and unified countermeasures to prevent localized issues from escalating into systemic crises.

Question: You have indicated that the financial risks in the real estate market are often misunderstood as a singular issue. Could you explain this viewpoint in detail?

Li: A common misconception is that financial risks in the real estate market are confined to the housing sector, neglecting the potential systemic financial vulnerabilities. The real estate market’s heavy reliance on pre-sales and debt financing renders it particularly susceptible to economic fluctuations and declines in investor confidence.

When market conditions shift, the confidence of both developers and investors can deteriorate rapidly, triggering a domino effect that further destabilizes the financial system. Inadequate responses to the emerging financial risks in the real estate sector magnify adverse effects on the economy, damaging the credit ratings of prominent developers and leading to a general decline in market confidence, which could ultimately result in the depreciation of the renminbi. Effective management of these risks necessitates interdepartmental coordination.

Question: Why does the management of these risks require inter-departmental coordination? What deficiencies exist in the current mechanisms?

Li: The conventional segmented regulatory model is hampered by “departmental walls.” For instance, the debt restructuring processes involving real estate companies touch upon multiple entities, including the Ministry of Housing and Urban–Rural Development, the People’s Bank of China, the China Banking and Insurance Regulatory Commission, and various local governments.

Conflicting objectives among these stakeholders complicate the situation: financial institutions prioritize maintaining asset quality, local governments focus on sustaining land-based fiscal revenues, while regulators aim to avert systemic risks. Therefore, establishing an inter-departmental coordination mechanism is essential to facilitate rapid and cohesive responses, preventing localized challenges from evolving into systemic crises.

Systemic “titanic” risks

Question: In your earlier speech, you compared long-term “Titanic” risks to systemic risks; why are these types of risks easily underestimated?

Li: Long-term systemic risks can be likened to the “Titanic hitting an iceberg.” These risks are often underestimated until they become uncontrollable. A pertinent analogy is the late economist Rudi Dornbusch’s observation on macroeconomic risks, which, once manifested, exert overwhelming and irreversible effects.

In the context of China, two significant systemic risks stand out: local government debt and economic imbalance.

Question: Regarding local government debt, could you provide a detailed overview of the current situation and its potential sustainability issues?

Li: Presently, China’s local government debt is alarmingly high, estimated to range between 70 % and 90 % of GDP, with the International Monetary Fund (IMF) estimating it at approximately 110 trillion yuan, indicating a clear lack of sustainability.

Historically, this type of debt has been directed primarily toward infrastructure financing. While such projects yield long-term benefits, they depend heavily on short-term commercial debt for funding. To resolve the mismatch between the repayment pressures associated with local government short-term debt and the long-term returns from infrastructure investments, there is a pressing need to transition toward financial instruments such as the issuance of long-term bonds.

It is important to note that, in comparison to its relatively high national savings rate and abundant state-owned assets, China’s overall debt level remains comparatively low. This situation provides an opportunity for the expansion of long-term bond issuance. Such a shift would effectively mitigate short-term financial pressures and enhance overall fiscal stability. Therefore, it is essential to optimize fiscal policy adjustment strategies.

Question: You have mentioned that, compared to the national savings rate and state-owned assets, the debt level in China remains relatively low. How does this phenomenon affect debt management and financing structures?

Li: Although local government debt is significant, the overall debt level in China remains comparatively low, creating room for increased issuance of long-term bonds. A high national savings rate suggests a robust flow of funds into the market, while plentiful state-owned assets provide a solid foundation for enhancing debt management and improving credit ratings. This indicates that if these resources were effectively harnessed to promote the issuance of long-term bonds, we would be well-equipped to address the risks associated with local government debt.

Question: In your earlier speech, you mentioned how economic imbalances, particularly the imbalance between production and consumption, constitute another long-term systemic risk. What are the specific manifestations of this imbalance?

Li: The imbalance between production and consumption is reflected primarily in policy orientation. Under production-oriented tax incentive policies, local governments often prioritize production over consumption. This emphasis suppresses consumer demand and exacerbates competition within the production sector. Such a situation not only undermines the healthy development of the economy but may also result in a decline in overall societal consumption capacity, adversely impacting economic recovery and growth.

Reforming the tax system to allocate value-added tax (VAT) revenues to consumption regions, along with adjusting performance assessments to emphasize per capita income and consumption growth, are crucial steps toward achieving economic rebalancing.

Proposed reforms

Question: You have stated that establishing a sound reform mechanism for the financial sector is a critical measure to address risks. Could you elaborate on the specifics and importance of this mechanism?

Li: The increasing prominence of financial risks poses a significant threat to economic stability, with the potential vulnerability of the financial system leading to systemic crises if not addressed promptly. Therefore, it is crucial to undertake coordinated actions swiftly, establishing an interdepartmental rapid crisis response mechanism. This mechanism would facilitate information sharing among relevant sectors and enable timely responses to emerging risks, thereby mitigating the extent of risk proliferation.

Specifically, this can be operationalized by forming a cross-departmental coordination group tasked with conducting regular risk assessments and emergency drills. Such preparations ensure that, in the event of a financial crisis, all parties can respond rapidly and implement effective countermeasures.

Question: Regarding the optimization of fiscal policy adjustment strategies, how do you think local debt should be managed to ensure sustainable economic development?

Li: The persistent growth of local government debt represents a substantial challenge to sustainable economic development. If not managed properly, it may threaten financial security and destabilize local economies. One effective approach to managing local debt is through the issuance of long-term bonds, which can relieve short-term repayment pressures on local governments and facilitate the successful execution of long-term projects such as infrastructure development.

In practical terms, it is essential to leverage China’s robust savings rate and state-owned assets for effective debt management. This approach will enhance both the efficiency and transparency of fund utilization, while also necessitating the establishment of a supervisory mechanism for local debt to curb risks associated with excessive debt expansion.

Question: You have highlighted the importance of tax reform in stimulating consumer demand. How should the distribution strategy of VAT be adjusted?

Li: The structural imbalance between production and consumption has become increasingly pronounced within China’s economy. Consumer spending is vital for driving economic growth, and targeted tax reforms can significantly enhance consumer demand. By redistributing VAT revenues to consumption regions, we can incentivize local consumption, thereby promoting domestic demand growth and enhancing economic sustainability.

Adjustments to the distribution ratio of VAT should be informed by actual consumption conditions across different regions, facilitated through local government implementation, to stimulate consumption and rebalance the production–consumption relationship. Additionally, post-implementation evaluations are essential to ensure policy flexibility and adaptability.

Question: In your earlier speech, you raised the idea of reconstructing performance evaluation frameworks for local governments. What do you hope to see with the changing the existing performance assessment system?

Li: Currently, the performance evaluation frameworks for local governments tend to place excessive emphasis on production targets while neglecting improvements in residents’ income and consumption levels. This oversight provides insufficient incentives for local governments to foster economic transformation. By shifting the focus of performance metrics from solely production goals to include income and consumption growth, local governments can be motivated to prioritize the enhancement of residents’ living standards and the optimization of economic structures, ultimately improving the quality of economic development.

A revised performance assessment system should be established to delineate the weight assigned to various dimensions, such as income growth and consumption expansion. These metrics should be integrated at the local level with resource allocation and incentive measures. Furthermore, through data monitoring and periodic evaluations, we must ensure the scientific validity and operability of the new indicators, allowing for continual refinement and optimization in practice.

Question: Overall, what are your expectations and outlook for the future development of the Chinese economy?

Li: In summary, the Chinese economy faces dual challenges posed by short-term “fire-fighting” risks and long-term systemic risks. To effectively navigate these complex economic conditions, a comprehensive multi-faceted approach is necessary, encompassing deepening financial reform, optimizing fiscal policy, revising the tax system, and reconstructing the performance evaluation framework. These measures are not only critical for addressing current risks but also serve as key drivers for ensuring sustained growth and stability for the Chinese economy as it enters a new stage of development.