Economy

China’s Achilles heel

Beijing is worried that local governments could create $439 billion of NPLs

It's a long way down

Last June a 13 storey building in Shanghai caused a sensation. That’s because rather than standing vertical, it ended up horizontally on its side. The apartment block – located in the Lotus Riverside complex – became a cause célèbre throughout the country. It was akin to China’s very own Leaning Tower of Pisa, except in this case it had toppled all the way over.

No surprise perhaps that the building’s developer saw its two major shareholders in court this week making guilty pleas. The contractor had already got a three year prison sentence.

For many this will just be yet another cautionary tale about shoddy Chinese construction practices. But perhaps it could also serve as a worrying metaphor for local government finances. That’s because just like Shanghai’s supine tower, they’re slipping fast and are in danger of toppling over entirely.

The reason is simple enough and has been touched on briefly by WiC before (see Talking Point, issue 48). To recap: during the crisis the central government harried local governments to build infrastructure as a way to stimulate the economy.

To fund this local governments created financing platforms that operated like quasi-government departments. Their mission: to persuade state-owned banks to lend to local construction projects and local state-owned firms. The banks did so because these ‘financing platforms’ – of which there are suspected to be around 3,800 – provided a local government guarantee on any borrowing. That seemed sound enough.

But perhaps not. It now looks like local governments have been borrowing well beyond their means. The Chinese Academy of Social Sciences thinks that around Rmb5 trillion was raised via these financing platforms last year. Victor Shih, a professor with Northwestern University in the US, estimates the figure is even higher at Rmb11 trillion.

Says the Wall Street Journal: “Regulators in Beijing, worried that local governments won’t be able to pay back all the loans, are increasing their scrutiny of this kind of debt.”

It is principally the activities of these local government financing platforms that has got the regulators worried. That’s because it’s hard to estimate how much of the bank lending has been splurged on projects which won’t make a return sufficient to cover debt repayments. (Shih reckons Rmb3 trillion, or $439 billion, could go ‘bad’).

Hence in recent days – according to the 21CN Business Herald – the State Council has asked local governments to provide detailed information on the scale of their debt guarantees. The message coming from Beijing is clear. The stimulus got China through the crisis; now it’s time to call a halt to the local government borrowing binge that made it possible.

The flipside of the problem, of course, is the state of local government revenues. In China, the central government takes the lion’s share of corporate and personal income taxes, and that has left local governments with a fiscal dilemma: how to raise sufficient funds. The answer has been to rely on the property market. The one thing local governments do have control of is land sales.

For the moment, that strategy has worked. The 21CN Business Herald comments that the city of Beijing’s revenues from land sales have grown “geometrically” since 2006. In 2009, for example, land sales generated Rmb93.2 billion, or 46% of the city government’s revenues.

Such a lopsided reliance on property sales is not restricted to Beijing. In Shanghai, the city got 41% of fiscal revenues from land sales last year. Statistics show that Hangzhou was the most reliant on land sales, but the trend was nationwide: in 70 major cities the revenues from land sales soared 140% in 2009.

“At present, half the tax revenue of the majority of cities comes from the real estate industry,” writes the 21CN Business Herald.

Quite aside from fiscal debates, this is causing social problems too. With city governments keen to sell prime locations to developers, they have resorted to forced demolitions – i.e. knocking down homes. In December, a 47 year-old woman in Chengdu died after she doused herself in petrol and set herself alight in protest at the forced demolition of her home (see WiC45). A Shanghai resident – Cheng Laifa – recently elected to imprison himself in his own home, surviving on noodles, to fight a forced demolition.

Whole communities have been hit – the Shanghai government obtained 1 million square metres of land last year by relocating residents. Those affected complain they are inadequately compensated. But the China Daily quotes a Shanghai lawyer as saying the government is “lured to forced demolitions given the huge profits in land sales, which contribute heavily to local revenue.”

Analysts see looming problems with this dependence on property sales. First, it can’t last: eventually the mayors will run out of land to sell, and people to relocate from prime urban areas. That may already be happening: the city of Beijing is forecasting that its own land sale revenues will grow by a much-more-conservative 9% this year.

Second: it creates enormous vulnerabilities. What happens if – like in 2008 – the property market dramatically weakens? How do government revenues cope when their main income source is squeezed by a shrinking demand for land? Shanghai’s government, for example, must be worried that property transactions fell 51% in January and 54% in February (in terms of squares metres sold). That indicates weaker conditions in the real estate market.

For policymakers this is the source of many sleepless nights: they know if they pop the country’s growing property bubble, they will devastate local government finances. The knock-on effect of this is also frightening: with their revenues from land sales crippled, the local authorities will be even less able to service the huge number of loans incurred during last year’s stimulus.

China has proven adept at managing its economy and avoiding worst case scenarios. But if the worst case scenario does arise this time round, local governments will likely leave the banking sector riddled with bad loans.

Put simply, that’s why local governments are now the weakest link in the Chinese economy.


© ChinTell Ltd. All rights reserved.

Exclusively sponsored by HSBC.

The Week in China website and the weekly magazine publications are owned and maintained by ChinTell Limited, Hong Kong. Neither HSBC nor any member of the HSBC group of companies ("HSBC") endorses the contents and/or is involved in selecting, creating or editing the contents of the Week in China website or the Week in China magazine. The views expressed in these publications are solely the views of ChinTell Limited and do not necessarily reflect the views or investment ideas of HSBC. No responsibility will therefore be assumed by HSBC for the contents of these publications or for the errors or omissions therein.