SHANGHAI -- The Chinese economy may appear to be benefiting from a second wind, but a host of problems remain not far from the surface, ranging from a swelling real estate bubble to excess capacity at state-run enterprises. Many local governments are saddled with a pyramid of debt.
The administration of President Xi Jinping is acutely aware of the need for radical structural reforms, but is weary of sparking an economic downturn. China's once thriving economy now finds itself at a major turning point.
The real estate market is showing growing signs of a boom. Annualized prices for new homes rose in 62 out of 70 large and mid-size cities surveyed in August, up from 58 in July, China's National Bureau of Statistics reported on Sept. 19.
Especially in some "second-tier" cities like Nanjing in Jiangsu Province and Hefei in Anfui Province, new house prices surged by as much as 30-40%.
"Speculators who see prices in Beijing and Shanghai as too high have flooded into properties in surrounding cities," said Yan Yuejin, a Shanghai-based real estate analyst.
Propping up the real estate market are banks which cannot afford any more bad debt, despite a massive glut of liquidity.
Generally in China, banks offer mortgages worth up to around 70% of the value of the property. Banks tend to think that such loans are less likely to sour because they are secured with collateral.
New loans supplied by commercial banks in China grew by 900 billion yuan ($134 billion) in August. It is estimated that some 670 billion yuan, or around 70% of the total, were housing loans.
However, many homes have been bought by individual speculators, whose debt repayments eat up nearly 40% of their annual income, according to early September reports by Chinese media. That is even higher than the debt-income ratio in the U.S. during the subprime loan bubble.
A sudden decline in swollen real estate prices could result in even more bad loans.
As of the end of August, a total of 194 "land kings" emerged nationwide, with the number for the full year expected to hit a record high. The term refers to premium land plots provided mainly by local governments which are bought up by high-powered real estate developers for the highest prices.
The growing number of land kings indicates that developers are betting on continued rises in house prices, while also spurring individual investors.
Their proliferation is also generating fresh revenue flows for local governments.
In Hangzhou, the capital of Zhejiang Province, which imposed restrictions on the purchases of houses on Sept. 19, the highest price for a land parcel sold by the municipal government so far this year was 12.3 billion yuan. The city has earned a total of over 100 billion yuan through land sales, three times the figure for the same period last year.
Land sales now account for more than half the revenue of the governments of Hangzhou, Hefei and Nanjing.
Many local governments spend the money to promote infrastructure development, usually through state-run enterprises under their control, in an effort to achieve growth targets imposed by the central government.
But imprudent spending has led to the shadow banking problem. Huge amounts raised by developers under local government control through risky loans disguised as investment products have become unrecoverable.
In a report published in late September, the International Monetary Fund urged the Chinese government to temporarily suspend setting economic targets.
Excessive infrastructure investment by local governments appears to have declined, but the trend could be revived by the current real estate bubble.
Meanwhile, Chinese banks are making little headway in their efforts to dispose of bad loans. One way for them to get the loans off their books is selling them through online auctions.
In one example, a condominium unit in central Hangzhou was recently offered for 2.3 million yuan on an online auction website open to individuals. Many of properties being sold through online auctions are repossessed collateral.
Chinese banks have started taking some drastic steps to write off bad debts, such as bulk sales and securitization.
During the first six months of this year, China's four largest commercial banks disposed of 130 billion yuan in bad debts.
Still, the total of bad loans they held grew by nearly 10% from a year earlier to 746.5 billion yuan. For the entire banking sector, the amount spiked by 13%.
It is too early to say that the back of the bad debt problem has been broken, warned Yi Huiman, chairman of the Industrial and Commercial Bank of China(ICBC).
The problem is that it is unclear just how big the debt mountain will become. Of the roughly 2,900 companies listed on mainland stock markets, more than 400 reported net losses for the first half of this year.
If the earnings performances of listed companies are so dire, the financial results of most unlisted companies, including many "zombie companies" under local government control, do not bare thinking about.
Since the beginning of this year, Dongbei Special Steel, of which Liaoning Province is the majority owner, for instance, has defaulted on bond principal and interest payments worth nearly 5 billion yuan.
But the company has been kept alive by the local government, which, fearing huge job losses, has asked the local lenders to keep supporting the steelmaker.
Pushing through structural reforms to pull the plug on corporate zombies and trim excess capacity, however, could rock the entire Chinese economy.
In a report published in late September, U.S. credit agency Standard & Poor's said carrying out reforms to address excess capacity amid slowing growth would risk a sharp increase in losses suffered by banks.
Wuhan Iron and Steel(Group), which has agreed to be acquired by Shanghai-based Baosteel Group, is the oldest major steelmaker in China and known as the "eldest son of the republic." The company employs tens of thousands of people in Wuhan, the industrial hub of Hubei Province.
During merger talks in March, a senior executive at Wuhan Iron and Steel(Group) said 40,000-50,000 of the company's 80,000 workforce would have to be redeployed.
The worry is that job cuts could trigger similar moves at related companies, said Xiao Minjie, senior economist at SMBC Nikko Securities.
In the late 1990s, then Premier Zhu Rongji spearheaded a radical banking reform to rebuild the financial system, which involved the creation of a new fund to buy bad loans from the big four banks and injecting fresh capital into the lenders.
The government had to spend enormous amounts of money to clean up the mess.
The challenge of tackling the bad debt problem now is even more daunting because of the real estate bubble and the greater scale and complexity of the problem.