China’s property developers are facing a reckoning with their outsized debt burdens. Evergrande Group may have avoided defaulting on its bonds for now, but several of its peers have already done so. Nervous consumers are holding off from buying homes — property prices dropped for the first time in six years in September.
As the music stops for property developers, fewer of them are buying new land. More than a quarter of land parcels offered at public auctions in September reportedly went unsold, the highest rate since 2018. That will have grave implications for China’s local governments, key drivers of Chinese economic growth which for decades have leaned heavily on land sales to generate revenue.
This week, The Wire explains how China’s property downturn could shake China’s local governments, looking at which regions are most at risk, and whether a controversial new property tax could help solve local government’s fiscal woes.
LAND AND THE LOCAL GOVERNMENT
In the U.S., property taxes are the largest source of local government revenue in most states. Not so in China, which lacks a national property tax. Instead, around 40 percent of local government revenue comes from land sales on average. Add in tax revenue from development and related activities and that percentage increases to over half.
Beijing laid the foundation for this reliance on land sales in 1994, when it dramatically reduced the share of tax going to local governments in favor of the center. Local governments were also prohibited from borrowing and issuing bonds, even though Beijing was simultaneously putting them under heavy pressure to spend more to meet high growth targets.
Land sales thus became one of the only available means for local governments to generate revenue. After the global financial crisis in 2008, many also circumvented the borrowing prohibition by forming companies to take out off-balance sheet loans, known as local government financing vehicles (LGFVs). Land was used as collateral for many of these LGFV bonds, further tying the fates of local economies to property development.
Since 2015, Beijing has been trying to cut back on excessive local government borrowing. In turn, LGFVs are finding it harder to borrow across all lending channels for the first time this year, according to consultancy Rhodium Group. Funding costs for LGFVs have been rising, too, meaning a greater proportion of local government spending is going towards interest payments.
The upshot is that just as land sales are falling — creating a funding hole which exceeded $1 trillion last year nationwide — new financing channels for local governments have also become restricted.
To plug their funding shortfall, local governments are turning to issuing special bonds, which they have been allowed since the ban on direct local government borrowing was lifted in 2014. These instruments are supposed to fund new infrastructure projects, but are instead being used increasingly to refinance existing loans and recapitalize local banks, according to Logan Wright, a director at Rhodium Group.
“There’s this plan to build this much infrastructure, but the reason that this bond issuance keeps expanding is because you have this deficit that comes from declining land sales relative to rising local government expenditures. [Special bonds have] been the offset,” he says.
A downturn in property development-related economic activity could also hurt indirect tax revenues such as VAT and turnover tax that contribute to local governments’ ordinary budgets, through which they pay for public goods such as hospitals and schools, according to Dinny McMahon, author of China’s Great Wall of Debt.
The bigger picture is that the pressure on local government finances is likely to hurt China’s economic growth, since it will make it harder for them to boost infrastructure spending, a crucial driver of China’s economic growth for years.
Analysts also fear that LGFVs, unable to secure new lines of credit, may be close to defaulting, an outcome that could unleash turmoil in China’s bond market. “We view it as a very high probability that LGFV bonds will default, and then after the initial taboo is broken it’s quite possible that you could have multiple defaults take place, because the political cost of doing so will be seen as reduced,” says Wright.
PROPERTY TAX
As the budgets of local governments get squeezed, China’s top leaders are again discussing a national property tax. Last Saturday, the National People’s Congress Standing Committee passed a pilot program that would trial taxing property in about 10 cities.
Much of the discussion around the property tax has focused on its potential role in reining in real-estate speculation as part of Xi Jinping’s “Common Prosperity” campaign. But some proponents have also highlighted its potential as a direct source of revenue for local governments.
Rhodium’s Wright argues that levying such a tax now might only end up hurting demand even further: “The irony of the property tax discussion is that where you’re applying the property tax, you probably don’t need it for local government revenue creation, and where you need it for local government revenue creation, you’re probably not going to apply it, because you’re concerned about its impact on the property market.”
Beijing’s desire for central control may also make it reluctant to allow a property tax to replace the current revenue-sharing system with local governments. Remittances from the central government often help to plug some of the local government revenue gap, but they usually come with earmarks that allow the central government to dictate how the funds are spent.
“Local governments have borrowed in the past just to create short-term economic growth, the consequences be damned,” says McMahon. “With the current allocation of tax resources, local governments don’t like it, but the central government likes it to the extent that it continues to give a certain degree of authority over local governments, because they’re dependent on remittances from the central government.”
Eliot Chen is a Toronto-based staff writer at The Wire. Previously, he was a researcher at the Center for Strategic and International Studies’ Human Rights Initiative and MacroPolo. @eliotcxchen
