Oct 16, 2015 | 09:02 GMT

10 mins read

China: No Easy Cure for Local Governments' Addiction to Real Estate Revenue

Buildings under construction near the People's Bank of China office building in Chongqing.
(CHINA PHOTOS/Getty Images)

As China's economic slowdown ravages domestic property markets, Beijing is implementing supportive policies to ease the pain on China's local economies, as well as its overall national economy. Yet these policies do not resolve the underlying structural problem: local governments' financial dependence on real estate markets. This dependence has made local governments reliant on Beijing, giving the central government significant influence at the local level. Thus, as Beijing revisits its fiscal relationship with local governments, it will have to determine how much control it is willing to give up to rectify inefficient economic practices. To preserve its primacy, Beijing will seek to control the regulatory framework governing the financing of local governments while it pursues economic and fiscal reforms.

China will continue to experience economic woes in its housing sector. New home prices in cities outside the major conurbations have remained stagnant in the face of oversupply. While prices did improve in so-called first tier cities (such as Beijing and Shanghai) and some second tier cities (such as Dalian and Harbin), new land purchases are down by a third. Housing prices in third- and fourth-tier cities, which are categorized by their lack of population, GDP, infrastructure and cultural or historical significance, have decreased continuously. Oversupply in housing stocks will mean third quarter measures to stimulate home buying will fall flat in the fourth quarter.

The sum of this will stymie China's efforts to build up an inland consumption base during the quarter. Investment into real estate development is so unattractive that construction by floor space continues to decline by 16.8 percent on an annual basis. However, completion rates are rising thanks to a backlog of previous investment deals. This further dampens the market outlook as inventories build up while prices are slow to recover.

Local governments still rely on land sales for approximately 35 percent of their revenue, and the construction and housing sectors play an important role in driving demand for industrial products such as steel and cement. Thus, the drag on the property markets has contributed greatly to the overall economic slowdown in China. To mitigate the severity of the economic slowdown, Beijing has implemented policies that support the real estate sector, including providing easier access to mortgages and allowing foreign participation in the market. First- and second-tier cities could benefit from these policies because their demands are relatively robust, but costs and stringent regulations have limited purchases. However, these policies will be less effective in lower-tier cities because urbanization still favors traditional municipal centers. Moreover, these policies will not address the core structural problems of overcapacity and inefficiencies in the real estate development sector.

The Vital Economic Role of Real Estate

Any improvement in housing prices is important to embattled real estate developers attempting to survive China's economic slowdown. Many developers fueled their unsustainable growth with large, short-term, external loans by taking advantage of low interest rates in developed economies, mainly the United States, since the 2008-2009 global financial crisis. To avoid going deeper into debt or insolvency, these firms will need property prices to at least stabilize, if not rise.

The importance of real estate developers and property prices to the growth of local economies cannot be overstated. The central government takes 48 percent of total tax revenue nationally but is responsible for only 20 percent of total national fiscal expenditures. This skewed fiscal relationship between the central and local governments means that revenue from property development and land sales have helped bridge the gap in local government budgets. The central government has tried to reduce local governments' dependence on land sales and property development for revenue, but statistics and anecdotal reports show that this has been largely futile. Local governments are reluctant to give up the ability to fill budget gaps (and their coffers), particularly during a nationwide economic slowdown.

Entities known as local government financing vehicles use land sales and properties to back debts accrued by these governments. The funds these vehicles have raised have largely gone into real estate and property investment projects, but as the property market slows and the economy weakens, local governments' ability to repay these debts is threatened. The biggest risk is a moral hazard issue that would involve the central government doing everything in its power to prevent a collapse: No one expects Beijing to let a provincial government go bankrupt if it cannot repay its obligations. Even if a local government goes insolvent, the market assumption is that the central government would bail out the state-owned banks experiencing heavy losses generated by lending to failed real estate investment projects.

For Beijing, mitigating this risk involves creating new ways to refinance insolvent property investment projects while spreading the risks over a longer time frame and among more participants, including foreign investors. Though a lot of the risks are financial, both the local and central governments understand that the real estate development sector has been a major employer in China and that supporting the sector will prevent sudden large-scale unemployment, which would lead to greater social unrest.

Supportive Economic Policies

Beijing's supportive economic policies have likely contributed to minor price improvements in the real estate sector. Policy changes include lowering second home down payment requirements to 40 percent from 60-70 percent while giving local and provincial authorities greater control over setting mortgage requirements to accommodate for varying economic conditions. Chinese authorities also lifted a ban that prevented foreign nationals and institutions operating in China from purchasing or funding the purchase of first homes by expatriates. Additionally, foreign nationals are now eligible to borrow locally for first-time home buying.

Aside from policies specifically targeting real estate, Beijing has enacted a series of macroeconomic easing policies that help support and stabilize the real estate sector. These policies include multiple interest rate cuts and reserve ratio reductions that loosen credit conditions within the Chinese economy. The change in China's currency regime, which led to a weaker yuan, has also provided a new avenue to help troubled real estate developers, who have incentive to either swap foreign currency debts for domestic ones or to pay them down to be eligible for supportive domestic economic policies

Beijing's Bigger Strategy

The depressed property prices that linger despite China's efforts to prop them up stem from Beijing's fundamental dilemma: how to restructure the fiscal relationship between Beijing and the local governments. China is experimenting with new ways of financing local government budgets by developing the bond markets and using them to stretch out the due dates for a great deal of local government debt. This will at least buy many local economies more time to implement incentives and reforms to generate new demand for local housing stocks.

To use its bond markets to discipline and save local governments' budgets, China would need greater private corporate participation, but foreign capital and best practices could transform the traditionally small bond market into a potentially international one. Bringing in foreign capital to China's financial markets, particularly the bond markets, will provide fresh money to recapitalize indebted local governments and property developers. Moreover, it contributes to Beijing's larger policy goal of internationalizing the yuan by providing a deeper financial market and larger financial system for foreign investments. However, the government will have to be careful not to make the same mistake it did with the stock market by allowing overvaluations, overleverage and risks to be masked. Beijing's poor handling of the stock market crash in mid-2015 spooked international investors and lowered the Chinese government's credibility in handling economic policies. The poor communication with financial markets and knee-jerk policy responses also decreased the yuan's chances of becoming a staple of global financial stability in the near term

Greater usage of the yuan has made the yuan-denominated bond market more attractive to investors. Moreover, during the last year, Beijing has implemented policies to expand its financial markets — creating more financial products and giving banks and financial institutions more ways to do business — by giving them more regulatory structure and accessibility. The main policy change grants foreign financial institutions and central banks unrestricted access to China's interbank bond markets, where 95 percent of China's bond transactions occur. The first uninhibited issuance of a yuan-denominated bond by HSBC — a foreign bank — in China's interbank markets on Sept. 22 became the first test case of the new economic policies. Though HSBC is just testing the waters for financial access, the entrance of more foreign financial institutions could breathe new life into China's indebted real estate developers and diversify the immediate economic risks among foreign investors in yuan terms and over a longer timeframe.

Arguably, there are three main reasons for Beijing's focus on deepening its financial markets instead of trying to resolve real estate companies' underlying debt and stability problems. First, the scale of the local government debt has grown too large too quickly, making it indispensible to local government budgets and "too big to fail." Second, China has an opportunity to both attract foreign investment to help revive the housing sector and spread the inherent risk of a Chinese slowdown to foreign capital markets. Third, by using foreign capital and looser regulations to stabilize the property sector, China can buy more time to implement a comprehensive fiscal reform plan. This is crucial to Beijing's broader objective of changing the economic relationship between the local and central governments. Stratfor's assessment is that Beijing will have to overcome major hurdles before it can implement comprehensive fiscal reforms. Attracting foreign capital would give Beijing a viable shorter-term solution while it works out a reform plan.

Political Constraints and Preferences

The major obstacles to a reform of local government revenue sources include resistance from local property developers and authorities, which want to limit fiscal losses. Although weaning local governments off real estate development and land sales as a source of revenue is an important goal of reform, the transition would slow demand for property development and further depress property prices. The problem is that Beijing will want to preserve the central government's access to a large share of national fiscal revenues even as its expenditures remain relatively small. Failure to reform the fiscal relationship between Beijing and local governments and lessen the importance of real estate to local governments' revenues could jeopardize reforms aimed at reducing economic inefficiencies.

Reforming this relationship will most likely involve Beijing giving local governments more independence in managing and setting their own budgets and tax revenues. Moreover, Beijing will attempt to enact legal and regulatory guidelines to manage its fiscal relationship with the local governments and to minimize the central government's share of tax revenue. Giving local governments the fiscal space they seek would increase local officials' willingness to tolerate the short-term economic pains of turning away from real estate by giving them new sources of funding.

Beijing cannot control every risky financial activity or wasteful project; enforcement of anything is never 100 percent possible. For Beijing, the best option is to change the incentives and choices for local governments, giving them new avenues to fund budget gaps and service their large debts, while bolstering the economy and potentially creating new demand growth. Failure to do so will mean that the central government will have to shoulder the burden at some point, at a great cost to the national economy and budget. The current fiscal relationship has been crucial for Beijing to maintain leverage over local government policies, but it has pushed local authorities toward risky financial activities. Any future fiscal reforms will have to reduce this behavior while still granting Beijing the influence it seeks over local authorities.

As Beijing works out the details of fiscal reforms, it will use a mixture of disciplinary actions and anti-graft measures to shape local governments' political atmosphere while implementing new economic incentives to change how it manages local governments' fiscal activities. Anti-corruption drives can halt bad practices temporarily, but Beijing will need more permanent solutions involving longer-term changes in its fiscal relationship with local governments and new ways for these governments to generate revenue. 


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