cross-posted from: https://lemmy.sdf.org/post/51760900
Download full report: China's Financial and Fiscal Decay (pdf)
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There is a widening gap between Beijing’s targets (and data measuring economic performance) and the actual capacity of China’s policymakers to support domestic demand with the tools at their disposal. The best description for the weakness of China’s domestic economy at this point is not crisis or collapse but prolonged decay—the declining efficiency and effectiveness of policy tools, producing weaker economic growth as a result.
The roots of this decay can be found in China’s fiscal and financial systems. Beijing primarily influences the domestic economy through controls on the direction of domestic credit and government spending. But the overextension of these tools for political purposes over the past two decades has exhausted their effectiveness and capacity to guide China’s economy today. The financial system lends rising proportions of a smaller volume of new credit to unproductive local government and state-owned enterprises simply to prevent them from collapsing, while fiscal spending is largely executed via those same indebted institutions. The net result is a declining payoff in terms of investment and economic activity for the same volume of lending or fiscal spending, while private sector investment remains weak. As production outstrips domestic demand, domestic prices fall and surplus output must be sold abroad, widening China’s external imbalances.
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China’s domestic economy will remain weak this year, and export performance will be far more important for cyclical activity. China will unveil policies to support economic growth—interest rate cuts, special or single-purpose bond issues for fiscal spending, capital injections for banks—but none of these will provide anything more than a temporary break from previous trendlines toward deflation and economic stagnation.
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Banks are finding fewer clients willing to borrow at interest rates above 3% [which is China's loan prime rate, or LPR for short]. The more significant change is that this actually reflects a rising proportion of lending to state-owned enterprises (SOEs), and a declining proportion of lending to private enterprises. SOEs can typically pressure banks more effectively to reduce borrowing rates, particularly local SOEs and local government financing vehicles (LGFVs). The rise in the proportion of loans extended at or below the LPR points to the declining efficiency of the banking system in financing productive investments—the data has been consistent for years that state firms are far less efficient than private firms.
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The bottom line is that China’s commercial banks have been lending to the same borrowers in recent years, but even less efficiently. They are producing less investment growth with fewer loans, and generating lower profits per loan, and lower profits overall. That declining profitability will impact their capacity to recapitalize out of retained earnings and make more new loans, which means that investment growth and economic growth will stay weak.
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The deterioration in China’s fiscal conditions in 2025 was arguably more severe than the decay within the financial system. Tax revenues rose by 0.8% for the full year after a 3.4% decline in 2024, but non-tax revenues declined by 11.3%, after local governments were scolded for aggressively collecting one-off fines from businesses and entrepreneurs. The total decline in fiscal revenues was 1.7% outright. But as a proportion of GDP, tax and non-tax revenues fell nearly a full percentage point in 2025 to only 15.4%. This remains among the lowest recorded levels of the world’s economies (below Mexico and Colombia among OECD nations), and well-below OECD averages in the range of 34%.
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The decline in investment activity along with falling domestic producer prices directly impacts China’s tax base and the capacity to collect taxes. Interestingly, the Ministry of Finance did crack down on underreporting of individual income taxes in 2025, and produced an 11.5% rise in individual income taxes for the year. But these only represented around 9% of China’s total tax intake.
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The net result was a rapidly expanding overall government deficit, including both central and local government spending, reaching 9.0% of GDP for the full year [...] Should revenues continue declining in 2026, the deficit could widen to 9.5-10.0% of GDP this year. China can continue to finance widening deficits, but the commercial banks themselves are doing so. Hence there is little difference between fiscal spending and policy-driven lending within the Chinese system—they are executed by the same entities (local SOEs and LGFVs), and financed via the same banks, either in the form of a government bond or a loan. The only practical difference is the interest rate or profit to the banks.
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The most important implication of all of these developments is that the era of fiscal trade-offs has already arrived, and the stress is deepening. 2025 was more difficult than 2024, and this year will likely be more difficult than 2025. Beijing’s spending capacity or wherewithal in absolute terms is declining. The channels through which Beijing can utilize that capacity are increasingly inefficient in generating growth as well. This is what fiscal and financial decay looks like based on the granular data within the Chinese system.
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