Local governments in China are still building highways, bridges and railways, as shown here in Jiangxi Province on Sept. 6, 2024.
Cfoto | Future Publishing | Getty Images
BEIJING – China’s ongoing slowdown in consumption is due to the country’s sluggish property market, and its deep ties to local government finances – and debt.
The bulk of Chinese household wealth went into real estate over the past two decades, before Beijing began cracking down on developers’ heavy reliance on debt in 2020.
Now, those property values are falling, and developers are cutting back on land purchases. That’s taking a toll on local government revenue, especially at the county and district levels, according to S&P Global Ratings analysts.
They expected that local government finances would need three to five years to recover to a healthy state, starting in June of this year.
But Wenwen Huang, director of credit rating agency S&P Global Ratings, said in a statement to CNBC on Friday: “Delays in revenue recovery could prolong attempts to stabilize debt, which continues to rise.”
“Macroeconomic headwinds continue to hamper local governments’ ability to generate revenue, particularly in terms of taxes and land sales,” she added.
Local government finances have suffered from falling land sales revenues for at least two or three years, while tax and fee cuts since 2018 have reduced operating revenues by an average of 10% across the country, Huang previously told CNBC.
This year, local authorities are struggling to restore revenue, giving already stressed businesses little reason to hire or increase salaries — adding to consumers’ uncertainty about future income.
tax revenue recovery
As officials search historical records for possible wrongdoing by companies and governments, dozens of companies in China have disclosed in filings with the stock exchange this year that they have received notices from local authorities to pay taxes related to operations since 1994.
They said the amounts ranged from 10 million yuan to 500 million yuan ($1.41 million to $70.49 million), covering unpaid consumption taxes, undeclared exported goods, late payment fees and other charges.
Even in the relatively wealthy eastern province of Zhejiang, Ningbo Bohui Chemical Technology Co. said provincial tax authorities in March ordered it to pay 300 million yuan ($42.3 million) in adjusted consumption taxes, a result of “reclassification” of aromatic derivative extraction equipment it had produced since July 2023.
Jiangsu, Shandong, Shanghai and Zhejiang — some of China’s largest provinces in terms of tax and non-tax revenue generation — will see non-tax revenue growth of more than 15% year-on-year in the first half of 2024, S&P’s Huang said. “This reflects the government’s efforts to diversify its revenue sources, especially as its other major sources of income face increasing challenges.”
The development has caused a stir online and hurt already fragile business confidence. The CKGSB business conditions index, a monthly survey of Chinese companies, has been hovering around the 50 mark, which indicates contraction or expansion, since June 2023. The index fell to 48.6 in August.
Retail sales rose only modestly from their slowest levels since the Covid-19 pandemic.
“The pressure to reclaim taxes from years ago really shows how desperate they are to find new sources of revenue,” Camille Boulinois, associate director at Rhodium Group, told CNBC.
China's National Administration of Taxation acknowledged in June that some local governments had issued such notices, but said they were routine procedures “in accordance with law and regulations.”
The administration denied allegations of conducting “targeted nationwide and industry-wide tax inspections,” and said there was no plan to “retrospectively investigate” unpaid taxes, according to a CNBC translation of the Chinese text on the administration's website.
“Revenue is the main issue to improve,” Laura Li, head of China’s infrastructure team at S&P Global Ratings, told CNBC earlier this year.
“A lot of government spending is essential spending,” she added, such as education and civil servant salaries. “They can’t cut spending on that, unlike spending on land development.”
Discussion on how to stimulate growth
Growth is one straightforward way to boost revenues. But with Chinese authorities prioritizing efforts to reduce debt levels, it has become harder to shift policy away from a years-long focus on investment to consumption-driven growth, analysts say.
“What is being overlooked is the fact that investment creates weaker nominal GDP growth outcomes – putting pressure on the corporate sector to cut wage bills and leading to a sharp rise in debt ratios,” Morgan Stanley’s chief economists in Asia Chetan Ahya and Robin Sheng said in a September report with a working group.
“The longer the transition is delayed, the more calls will be made for easing to prevent a situation in which inflation and property price expectations become unmanageable,” they said.
Economists have pointed out that similar debt-reduction efforts from 2012 to 2016 also slowed growth, ultimately leading to higher debt-to-GDP ratios.
The same dynamic is playing out in this cycle, they said. Since 2021, the debt-to-GDP ratio has risen by about 30 percentage points to 310% of GDP in the second quarter of 2024 — and is set to rise further to 312% by the end of this year, according to Morgan Stanley.
They added that GDP is expected to rise by 4.5% from a year ago in the third quarter, “far from” the official growth target of about 5%.
“Grey Rhino” for Banks
Major political change is difficult, especially under China's strict state-dominated system.
The focus on investment lies in the complex interconnectedness of local government-affiliated commercial entities that have taken on large levels of debt to finance public infrastructure projects – often with limited financial returns.
The sector, known as local government financing vehicles, is “a bigger grey rhinoceros than real estate,” at least for banks, Alicia Garcia-Herrero, chief economist for Asia-Pacific at Natixis, said during a webinar last week. “Grey rhinoceros” is a metaphor for high-probability, high-impact risks that are being ignored.
Natixis research shows that Chinese banks are more exposed to loans from local government financial vehicles than to those from real estate developers and mortgage companies.
“Nobody knows if there is an effective way to solve this problem quickly,” S&P’s Lee said of the IMF’s problems.
“What the government is trying to do is buy time to solve the most pressing liquidity challenges so that it can maintain the overall stability of the financial system. But at the same time, the central government and local governments do not have enough resources to solve the problem immediately,” she added.
