In our Annual Forecast for East Asia, Stratfor highlighted the importance of fiscal reform to Chinese politics and the economy in 2015. New research by Deutsche Bank underscores that centrality — as well as the grave risks and challenges facing Chinese authorities as they attempt to shield local governments from the financial effects of anemic property markets and falling revenues from land sales. The dangers Deutsche Bank described stem from an emerging pattern of behavior by local government-affiliated financing vehicles (LGFVs), the notorious funding platforms that helped pay for China's post-2008 housing and infrastructure construction boom and whose borrowing accounts for the majority of China's nearly 18 trillion yuan ($2.9 trillion) in outstanding local government debt.
According to a Jan. 12 report in the Financial Times, LGFVs are buying an increasing portion of the land that local governments must sell to raise funds to pay for things like municipal infrastructure development and maintenance, social services, education, health care and, of course, the cost of servicing debts left over from years of frenzied construction and expansion. Ostensibly, this activity comes as a response to declining land purchases by property developers. That is, as housing markets cool and more property developers cut back on investments into new projects, local governments are turning to LGFVs to buy the land that developers previously would have purchased.
Given that LGFVs are not real companies with real assets and operations but merely shell companies created to raise funds for local governments, these purchases are almost certainly paid for on credit — though from where, at what rates and using what as collateral is unclear. In effect, Chinese local governments — which account for almost 90 percent of total government expenditures in China but take in only around 50 percent of government tax receipts (and often much less) — may be using borrowed funds to buy their own land from themselves (via LGFVs) and then using those borrowed funds to cover their manifold expenditures.
Problems in Practice
Just how widespread is this practice? According to Deutsche Bank economist Zhang Zhiwei, LGFVs likely accounted for 43 percent of total local government land sales in Jiangsu, a wealthy industrial powerhouse that forms the northern half the Yangtze River Delta region, in 2014. In Changzhou, a midsized city in Jiangsu, LGFVs may have bought as much as 70 percent of the land auctioned by the local government last year. Local governments in Jiangsu have a reputation for innovative — to put it politely — fundraising practices, so it is safe to assume that this phenomenon is less common in other regions, especially in the interior.
Nonetheless, considering that LGFVs already bought more land in Jiangsu than property developers in 2013 — indicating that the practice is already well underway — it is highly likely that LGFV land purchases are now fairly widespread. After all, 2013 was on the whole a positive year for Chinese property markets, marked by steady gains nationwide in home prices and home sales — not the sort of market conditions under which property developers would normally hesitate to buy land. 2014, by contrast, saw inexorable declines in home prices, home sales and real estate-related investment in virtually every major city across China. If LGFV land purchases already accounted for a large portion of land sales in Jiangsu, a major market, in a healthy year like 2013, then they could well account for a sizable chunk of land sales in many more, if not most, provinces now.
This news is especially concerning given a Jan. 5 deadline set by China's central government for local governments to determine which outstanding debts owed to banks in their jurisdictions classify as official government debts — and guaranteed support from the government and state-owned banks — and which do not. The days leading up to the deadline saw increased speculation that a substantial portion of LGFV fundraising activities would not receive the official imprimatur and would therefore be re-classed (and priced accordingly) as non-government debt. It is not known what portion of funds raised by LGFVs in 2014 will be re-classed and further, whether or to what extent these funds overlap with those used to buy land from local governments. But even if it is only a small fraction of the hundreds of billions of yuan in new debt raised by local governments last year, it nonetheless represents a significant addition to China's already looming corporate debt concerns.
The rise of LGFV land purchases underscores the urgency of fiscal reforms in China. As long as local governments remain heavily dependent on land sales as sources of revenue, and as long as local governments are responsible for the vast majority of government expenditures in China, they will continue to seek — and find — means of making those sales and generating that revenue, however unsustainable. As China's leaders understand, the antidote to this vicious cycle is to create new avenues for local governments to raise their own funds, namely, through municipal bond programs and, even more important, new taxes.
China's leaders, responding to these pressures, have begun to implement new measures designed to rebuild local government tax bases, from a new value-based resource tax on coal production to a property tax pilot program set to be expanded nationwide in 2015 or 2016. Once in place, these taxes will provide significant new sources of stable revenue to local governments, helping curb their reliance on land sales and on the inflated property markets that for so many years kept land prices high.
The challenge for Beijing is that a too-rapid implementation of taxes in an already deflationary economic environment runs the risk of provoking a much sharper economic decline than is socially and politically tolerable for China's leaders, especially if implementation is effective and comprehensive. Not only would this decline risk creating employment crises in many regions, but it would also cut into local government tax receipts, undermining its original purpose and further exacerbating local governments' needs for alternative funding sources. The Chinese government finds itself in a catch-22: the same fiscal reform that Chinese local governments need more urgently than ever is liable, if implemented too swiftly, to undermine the local economies those governments serve.