By Xander Snyder
For China, keeping economic growth sustainable keeps getting harder and harder. Last week, the Chinese government released a report that showed the annual growth of domestic fixed asset investment hit its lowest point in 22 years during the period from January to May. At almost 45 percent, investment is the largest component of China’s gross domestic product (ahead of consumer spending and exports). China needs to keep building construction and development projects to prevent a cyclical downturn from threatening employment and social stability. A slowdown in investment, therefore, portends a general economic slowdown. It’s important to understand its scale and what caused it.
Fixed asset investment is a broad category that encompasses all sorts of investments, including agriculture, construction and manufacturing, and infrastructure and services, so long as the investment is toward a physical asset. In China’s case, much of the reduced growth is a result of a slowdown in infrastructure investing (to 9.4 percent in the first five months of 2018, compared with 20.9 percent over the same period last year), much of which comes from China’s local governments.
China’s local governments are strapped for cash because Beijing is trying to rein in debt in its financial system. China’s happy growth story in the past few decades was made possible to a substantial extent by massive credit growth, which helped provide the capital for development. But that approach has a darker side: It fuels a property bubble that, should it burst, can wreak havoc on the economy.
Among the many financial hazards posed by the complex interconnectedness of financial and non-financial institutions in China and their lending to the real estate industry, local governments are a unique threat to Beijing’s goals. Local governments derive tax revenue from land transactions (technically, from the transfer of land use rights) to property and infrastructure developers. More credit for developers means real estate and construction companies can afford to buy more land at higher prices, and thus local tax revenue rises.
Local governments have tried to line their own pockets by getting more credit into the hands of developers. Technically, local governments cannot take on debt, so they have established so-called local government financing vehicles, whose affiliations to local governments are usually elaborate and hazy. These entities are often development companies, which take on debt and use that money to purchase land and pay local government taxes on the transfer. In essence, local governments are borrowing to fund their own tax income.
This scheme has created some obvious problems for Beijing. For starters, it has resulted in debt that is less transparent, such that the true scale of liabilities has been difficult to discern. Second, it’s a challenge to Beijing’s centralized authority. Local government officials are willing to borrow money now since they can implement more initiatives with the additional tax revenue, with the hope of moving on to a more important official position by the time the debt comes due. But with so much riding on its success with debt alleviation, Beijing cannot afford to have local officials defying its directives on borrowing activity. It makes bureaucrats and local bigwigs too powerful and makes Beijing appear too weak to manage them. The central government has needed to bring what remains of local power under its thumb and stamp out opposition to its national plans. Its deleveraging campaign, which has restricted the amount of credit available to local governments, is one way Beijing is bringing local governments to heel.
But it is not just local governments that are facing tighter credit. Beijing recently rolled out restrictions on wealth management products, a shadow banking security that contributed to the growth in opaque and difficult-to-assess securities. WMPs are often “off-balance-sheet” items, meaning banks do not report them, even if they own affiliated entities that issue the WMPs. This lack of transparency meant that Beijing couldn’t even understand the true scale of its problem. No longer – after forcing greater transparency in this market, Beijing has issued new regulations that are significantly decreasing the issuance of WMPs (by 20 percent in April on a month-over-month basis), and funneling that money toward other types of securities that are more transparent and less risky and are required to be reported by banks (“on-balance-sheet” items). And it’s not just WMPs that are falling. Total social financing – a broad measurement of credit issuance in China’s economy – fell by almost 50 percent from April to May to 761 billion yuan (about $120 billion).
All this said, it’s important to keep in mind that slower fixed asset investment growth doesn’t mean investment is declining. It’s simply growing less quickly. This is clearly not good for China’s growth prospects, but it’s a necessary part of the process.