China’s property sector crisis, set off by Xi Jinping’s “three red lines” policy, has taken a huge toll on the economy since late 2020. Property has occupied a dominant position in China’s debt-fueled growth model in the past two decades, taking up anywhere between 23% and 30% of the economy. To stimulate GDP growth, local governments use land as collateral and set up local government financing vehicles to borrow heavily from banks and promote urbanization and property development. Well-connected property developers purchase parcels of land at favorable rates from local governments, and in return they invest in infrastructure in those localities, which then benefit local economies. Local governments also make money off land sales and tax revenues from construction and other business activities from new property development. During the era of China’s rapid growth, when local government officials were promoted based on their local GDP performance, this seemed like a win-win model — until we ask the question, “where did all the money come from?”

The money that fueled China’s rapid urbanization and frenzied construction came largely from ordinary folks — the household depositors who parked their lifetime savings at Chinese banks and retail investors who bought sophisticated wealth management products that promised high returns, only to realize that their monies were thrown into risky property projects that, in more recent years, started generating negative returns. Essentially, the rapid expansion of the once-almighty property sector was funded by household savings. This debt-fueled growth model worked as long as there was money flowing as it did in the past two decades — until Xi’s imposition of the “three red lines” that abruptly constrained the cheap loans extended to property developers made possible by household savings that were underpriced. When the money flows or proverbial “musical chairs” suddenly stopped around 2021, many players found themselves without a seat.

The weakest link in the financial sector are the approximately 3,800 small and medium-sized regional banks, including city commercial banks, rural commercial banks, township and village banks, and rural credit cooperatives, which are more vulnerable than the larger ones. With combined assets of RMB55 trillion (US$7.5 trillion), they account for 13% of the total banking assets. In particular, the smaller rural banks are most vulnerable because they can only absorb savings from local depositors and are thus less financially diversified. Banking regulations bar them from establishing branches or offering online services to clients registered outside their home provinces. Due to their strong ties to local governments, they tend to lend to government-related projects, which renders their financial viability largely determined by the strength of their local economies.

Since the beginning of 2024, more than 60 of these rural banks have been dissolved or merged. These smaller banks have become the exception to the continued robustness of the Chinese banking institutions despite their liquidity issues. The system has not experienced a meltdown because the central government’s socialist system can instruct state-owned entities to absorb bad assets by diktats. Evergrande, the first property developer that became insolvent, has a total debt of US$300 billion, the size of Finland’s GDP. Despite the massive indebtedness of property conglomerates and enormous local government debt estimated between 55% and 75% of the country’s GDP, China’s financial sector has not yet come under severe stress. However, since 2019, bank runs have occurred in some of the smaller banks.

In 2022, when a group of depositors with the Village and Township Banks in Henan discovered they could no longer withdraw their deposits, they staged a protest at the provincial People’s Bank of China in Zhengzhou — only to be beaten up by plainclothes security guards. Zhengzhou, the provincial capital of Henan, is among the most notorious cities for “unfinished apartment projects” (lanweilou), a huge mess created by unscrupulous property developers, due to its rapid urbanization during the 2010s. Collaborating with brokers, the Henan rural banks bypassed their geographical boundary to absorb savings illegally from cross-country depositors by offering them higher savings rates. After the widely covered protest, in which the Henan authorities were accused of assaulting ordinary depositors who were defending their legal rights, the provincial banking authorities finally stepped in to honor all deposits (except those that were illegal).

Will the merging of these 60 or so rural banks resolve the banks’ balance sheet problems? Mergers of good and bad apples bring down the average of the good ones, though they may help absorb the bad assets of insolvents. It should be underlined that this is not the first time these small and medium-sized banks have undergone restructuring. As my earlier work on rural banks highlighted, the government tends to allow a proliferation of local banking institutions during boom times to facilitate credit expansion. During periods of rapid expansion, these small lending institutions are set up quickly, with corporate governance and reserve requirements often appearing as an afterthought. Banking regulatory authorities are then forced to clean up the mess during economic downturns. The expansion and contraction of rural banking institutions have mirrored the boom-and-bust growth cycles in the past few decades.

Even though these small lenders constitute only a small proportion of total banking assets in China, bank runs can erode people’s faith in the banking system, with ripple effects on social stability. Although the central bank’s insurance scheme, which guarantees up to 500,000 yuan of individual deposits, has only existed since 2015, deposits have always carried an implicit guarantee from the central government. There is a deeply held belief among Chinese citizens that “all banks belong to the state” (yinhang shi guojia de), that the central government will never let a bank go down under, and thus that their deposits are guaranteed even in a private bank. This ethos, though difficult to measure, undergirded the banking system’s stability during times of financial turmoil in the 1990s and 2000s.

Seen in this light, it is no surprise that the depositors in Henan organized collective action to defend their rights when they discovered that their savings were dishonored by the rural banks. And when the protestors were rounded up by unidentified security guards, they made international headlines. Their actions carried far more weight — and social consequences — than the size of the banks’ financial assets would foretell.