By Xander Snyder
The implications of China’s debt burden appear increasingly grim. We have previously discussed the relationship between the real estate market, China’s debt and retail investors who invest in securities of this debt, but local governments are also susceptible to the growing rot in the Chinese financial system. Stuck between a rock and a hard place as one of their primary sources of revenue has been cut back in recent years, local governments have taken on more debt to finance their expenditures. And their financial position appears to be deteriorating as well: On March 14, a Chinese official publicly warned that local governments are at growing risk of default.
Yin Zhongqing, deputy director of the National People’s Congress Financial and Economic Affairs Committee, warned that Beijing’s official figure for local government debt, $2.6 trillion, may be excluding more than $3 trillion of additional debt that is being hidden through a series of complicated public-private partnerships and other complex financial arrangements. Since most local governments in China are not legally allowed to borrow directly, they form arrangements in which companies or special-purpose entities – which are ultimately wholly or in large part owned by those local governments – borrow against future cash flows. That loan is then carried by the affiliated entity rather than by the local government itself, obfuscating the true scale of the local government’s obligations.
The Land Sale Boom
What’s driving local governments’ increased borrowing? Although local government debt may at first blush seem distinct from the country’s real estate debt concerns, they are in fact interrelated. The Communist Party technically owns all land in China, but property developers gain the rights to use and build on land by paying taxes to local governments. The taxes from these land sales (technically, the transfer of land usage rights) are a large portion of many local governments’ budgets. Since local governments receive more income the more land sales there are for development, they encourage real estate construction.
This conflicts with Beijing’s national goal of reining in property prices to contain the risk of a major price collapse, which could trigger a broader financial crisis. Beijing has seen some success with its property-related initiatives – over the past several months, property prices have remained stable or even declined slightly in a number of major cities. But disincentives toward new construction put local governments in a tough spot given their dependence on land sales meant for property development to generate tax revenue.
Beijing is aware of this conflict. One solution it has offered is a new property tax framework, presented in late 2017, that would emphasize taxes levied on property owners rather than on developers. This would be somewhat similar to the property tax system in the United States, where a percentage of the assessed value of the property is levied on the owner on an annual or semiannual basis. That said, a proposal and an implemented solution are two vastly different things, and there is a long way to go before a new property tax of that kind could plug the hole created by Beijing’s attempt to curb rising prices. As an example, in 2016, there were only two taxes on existing homes owned by Chinese citizens. They generated approximately $70 billion in revenue compared with the $550 billion raised from taxes levied on property developers.
When costs exceed revenues, the gap needs to be plugged somehow, and local governments in China have been doing that by taking on more debt. Yin points out that local governments, recognizing Beijing’s campaign to deleverage its financial system, have been increasingly vigilant in hiding their debt through public-private partnerships or other, murkier arrangements. Yin also notes that the official level of nonperforming loans in China’s financial system – approximately 1.7 percent – is substantially understated, kept artificially low by banks extending or amending underperforming loans to prevent them from being officially categorized as nonperforming.
As in other areas of its financial sector, China is running into the persistent challenge of overcoming the perception of implicit guarantees – the idea that Beijing will bail out any and all struggling local government financing vehicles. The central government could, to a degree, bail out LGFVs that struggle with repayment, but this becomes a far more difficult proposition with dollar-denominated debt. Though the People’s Bank of China can always print more yuan, doing so will put downward pressure on the currency. Inflation is always a risk when increasing money supply, but more money would at least make yuan-denominated debt easier to repay. However, cheaper yuan makes dollar-denominated debt costlier to repay, and according to the Bank for International Settlements, since early 2016 property developers have been issuing more dollar-denominated bonds than yuan-denominated bonds. Since many LGFVs are set up to fund infrastructure and property development projects, this means that local governments, too, are likely facing increased exposure to dollar-denominated debt. There are other policy options available to the central bank and the central government, but there are limits to how much money the government can print, so that is not a long-term solution.
In other words, real estate debt risk permeates all corners of China’s labyrinthine financial system. Perhaps the most salient manifestation of the scale of this problem is that Chinese leaders have become openly vocal about it. Yin is just one recent example. President Xi Jinping and his cadre have also spoken about the severity of financial risk facing the country. China’s leaders know that any such crisis will not be confined strictly to the economic realm and, knowing this, they are trying to mentally prepare the country now so it is not surprised when it happens. The looming question for China’s leadership is not when China will find itself in a crisis, but what exactly that crisis will look like.