Grasping Shadows: The Politics of China’s Deleveraging Campaign

China is currently facing a long-term, structural economic slowdown and rising risks of a financial crisis. Key contributors to China’s economic growth over the past two decades are fading away: demographic dividends, rising shares of global exports, a boom in residential property construction, and an unprecedented single-country expansion of credit and debt. Local governments laden with debt are increasingly unable to implement Beijing’s policy initiatives. An economic rebound after lifting Covid-related controls on citizens’ movement and activity is already underway this year, but all of the structural headwinds to China’s growth will persist.

The deleveraging campaign that China’s leadership launched in 2016 to reduce systemic financial risks is the only logical starting point to explain how China’s structural economic slowdown began. By reducing the growth of the “shadow” or informal banking system, China’s financial authorities cut credit growth in half and made it far more difficult for Beijing to power the economy using its traditional tools of credit-fueled investment by state-owned enterprises and local governments. Over the course of the deleveraging campaign, property developers continued expanding their own borrowing, inflating an unprecedented real estate bubble even larger before it finally burst in late 2021, amplifying China’s current economic distress. The deleveraging campaign marked the end point of China’s unprecedented credit expansion after the global financial crisis. 

But the legacy of China’s deleveraging campaign is complex. Had Beijing not taken the forceful steps it did targeting shadow banks starting in 2016, China probably would have faced a financial crisis far earlier, as its system became increasingly difficult to regulate and was already resembling parts of the U.S. financial system ahead of the 2007–2008 global financial crisis. Acting preemptively to control risks in one area of the financial system ended up creating them in another. China had previously used its financial system as a shock absorber for political risks from a slowing economy, rolling over loans and extending credit to unproductive enterprises in order to avoid unemployment and bankruptcies. After the deleveraging campaign cut rates of credit growth almost in half, China’s financial system can no longer play this role, and more credit risks and political consequences are now materializing within the economy, from banks to property developers and local governments. 

This report, by Rhodium Group partner and CSIS Trustee Chair senior associate Logan Wright, aims to objectively and comprehensively analyze the economic and political consequences of China’s deleveraging campaign, which are closely related to China’s current economic slowdown. The deleveraging campaign is an important test case of the adaptability and flexibility of the Chinese state to respond to meaningful economic challenges, such as the growth of the shadow banking system. The campaign reflected a series of monetary and regulatory policy choices, where Beijing was forced to calibrate its response to avoid creating unexpected shocks to the financial system, while still reducing systemic risks. 

In addition, the internal politics of China’s deleveraging campaign shifted over time, particularly as political power became more centralized under Xi Jinping in the late 2010s. The deleveraging campaign was successful in some of its objectives because China’s top leaders were narrowly focused on reducing financial risks, but maintaining a consensus behind this objective became far more difficult as the economy suffered. As tightening monetary policy gave way to new regulations, a consensus-driven approach to policymaking also gave way to a campaign-style system of economic governance, marked by periodic crackdowns against internet platform companies and the for-profit education industry. This year, the Chinese Communist Party took concrete steps to strengthen centralized control of China’s financial system, in what may presage another political campaign.

Beijing faces difficult strategic choices ahead as it confronts the end of the credit and investment-led growth model that has powered China’s economy for the past two decades. Restructuring local government debt and the central-local fiscal relationship are near-term imperatives, along with the need to unlock additional spending power for Chinese households to ensure more sustainable growth. Interest rates will need to fall in order to manage debt levels, creating incentives for capital outflows and corresponding pressures on China’s exchange rate. 

The rising risks within China’s economy and financial system also raise new policy questions for the United States in the context of rising systemic competition. Liberalization of China’s financial markets has been a long-held U.S. objective, but China’s limited convergence with global economic practices and norms has elevated political concerns about deeper linkages between China and global markets. The United States has a clear interest in regulating its own markets transparently, including Chinese firms’ participation in those markets, rather than attempting to influence or alter the calculations of risks and returns for investors in China’s financial markets. Beijing has plenty of challenges of its own attracting foreign investment given the headwinds China’s economy is now facing.

To the full report