China’s number one problem

In order to build the Lishui economic development zone, its boss, Wang Lijiong levelled 108 hills and mountains.

He did so by borrowing money from banks and employing a vast number of construction workers. They chopped the tops off the mountains and filled the valleys between the former peaks.

The result: flat land, on which new factories were built. Nearby farmland was then sold by Lishui officials to developers keen to build apartment blocks. The profits from the land sales boosted the local government’s treasury, meaning it could borrow more to build more roads and infrastructure.

The upshot was that this city in Zhejiang province – which you’ve most likely never heard of – grew fast: per capita GDP rose from $1,460 in 2006 to over $5,000 in the first quarter of this year.

The tale of Lishui and boss Wang is more than a feat of men moving mountains. It encapsulates one of the most talked about issues of the moment: the manner in which Chinese local governments have financed the explosive economic growth around them.

Long ignored, it has become a highly controversial topic. In WiC48 we first mentioned the concerns of banking regulators and economists that Chinese cities had run up colossal off-balance sheet debts that could create a wave of non-performing loans. We have returned to the issue on a couple of occasions since. But with the advent of the Greek crisis and wider worries about government debt around the world, it merits further exploration.

That’s why in this Talking Point we will seek to explain how China’s local government finances actually work, their malign connection to property bubbles and what the leaders in Beijing are trying to do to fix the burgeoning fiscal problem.

How are taxes split between Beijing and the local governments?

In 1994 the central government initiated a major fiscal reform designed to up its own percentage of the nation’s tax take. It was worried that its own share of taxation had fallen to around 20% of the whole, and that this diminished its authority.

Under its new plan the bulk of tax revenue was sucked into central coffers. That meant 75% of all con sumption taxes, as well as the entirety of taxes paid by the post office, the oil companies, the railway network and the state banks. For the remainder of companies, the centre takes 60% of income tax, leaving the localities with the thinner share. It also takes almost all stamp duties paid.

What did this leave the local governments? Not very much, it seems. They could charge local firms a business tax, as well as an urban land use tax (more on which later). But to plug shortfalls in their budgets, the cities now needed to rely on transfer payments from Beijing. In order to lobby for such support, they opened thousands of offices in the capital, to wine and dine powerbrokers for funds for their favoured projects. However, the central government ordered these offices shut last year – as it woke up to both their wasteful spending on entertainment and their potentially corrupting influence.

Luckily, the city governments had long before come up with a clever new way to plug the funding gap: selling land. The 21CN Business Herald comments that the city of Beijing’s revenues from selling land plots (to developers) have grown “geometrically” since 2006. By 2009, for example, land sales generated Rmb93.2 billion, or 46% of the city government’s revenues.

In Shanghai, the city got 41% of fiscal revenues from land sales last year. Statistics show that Hangzhou has proven the most reliant on land sales (55%) but the trend extends across the country. 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,” the 21CN Business Herald concludes.

How does this work?

The best analysis of this subject is Peter Hessler’s. In his recently published book, Country Driving (which WiC reviewed very positively in issue 54) he was one of the earliest to spot its potential problems – and particularly how it could expose the banks to bad loans.

Hessler spent a lot of time in Lishui working out how the system works. At the outset he looks at the challenges the city’s finance team faces: “Chinese cities have to raise much of their own funds, but by law they can’t issue municipal bonds, like American cities. They also can’t charge significant property taxes, because land is still nationalised. The tax base is weak, especially for a fledgling industrial region: in Lishui’s development zone, companies received tax breaks for the initial three years of production, and after that most would cheat on their earnings reports. It worked out well for the factories and the officials – they got favours and cash and all the Chunghwa cigarettes a man could smoke – but it was impossible for the city to survive on its tax revenue.”

Like the officials, Hessler soon grasped the potential for property arbitrage. In growing cities like Lishui, the local apparatchiks shifted peasants from their rural plots, which they then reclassified as ‘urban’ land. Pleasingly, that allows for a higher market value (not uncoincidentally, the Chinese character for ‘business’ literally translates as ‘buy dirt, sell land’).

Take the village of Xiahe on the outskirts of Lishui. Hessler describes how the city government acquired a small section of the village for just under $1 million, paying each resident $15,000 for the land they farmed.

Then the officials built roads and a sewage system and made a handsome profit by selling the development rights to a private company called Yintai for $37 million.

For city officials, this marriage of property speculation and infrastructure construction makes perfect sense. But, by itself, it is still not enough to meet their financial needs. Wang Lina, an economist at the Chinese Academy of Social Sciences, tells Hessler: “They can’t only sell real estate. Investors aren’t stupid – they know enough to wonder who is going to buy an apartment in a city that has no industry. In order to solve the problem, local governments often build a development zone, where they sell land-use rights at cost. The cheap prices attract factories, which provide some tax revenue, but the key is they expand the city. More bosses, more shopkeepers, more migrants – all of it means more suburbs and a better real estate market.”

Take that plot of formerly rural land bought by Yintai: it soon housed an apartment complex (of 28 buildings, no less). Yintai borrowed $28 million to fund the construction but forecast it could sell the flats for $700 million, roughly 19 times what it paid the government for the land in the first place.

Meanwhile, to attract more industry and make its land more valuable, Lishui development zone spent $8.8 billion on infrastructure. That investment (in just five years) turns out to be five times its total infrastructure spending in the previous half century.

Hessler concludes that if a city hopes to stay afloat, it must continually expand. And in order to build more infrastructure, the local government must rely on huge loans from state-owned banks – which it can only hope to repay if it can sell more land at ever-increasing prices. The system works so long as new investors come to build new factories, and a growing population buys new apartments. Which is – largely – the story of what has happened so far…

But will it always?

China has been growing at more than 8% per year for the last decade or so. But there are signs that the local government model is fraying at the edges. As WiC has reported repeatedly, it can lead to chronic social tensions as residents get moved off valuable land – especially in key cities like Shanghai and Beijing – to make way for skyscrapers and new roads. The resulting real estate boom has also seen apartment prices rise astronomically due to speculative buying. That can result in more social tension, as locals are priced out of the housing market.

Then again, it’s hard to wean a crack addict off his pipe. If anything, the local officials remain more wed to their growth model than ever. After all, they know of nothing else. As Richard McGregor points out in his just-published book The Party (see page 17): “The economy is driven by a kind of Darwinian internal competition that pits localities against each other… the pivotal role of local governments in promoting their own economy means that each locality operates in a way like a stand-alone company. Localities promote investment and strong-arm banks for loans.” The local Party secretary acts like a company CEO, McGregor says, with “near dictatorial powers” that make him a “lethal competitor” for rival business centres, especially neighbouring ones. And his key performance indicator is economic growth, the size of which determines how well he does at promotion-time.

The existing system has delivered growth, albeit frequently at a price. Ministry of Finance official, Liu Shangxi recently published an article in the China Reform magazine in which he pointed to the “defects” that the system can encourage. Liu puts tax proceeds at the heart of the problem and says local governments’ reliance on the current model – where they must attract industry to fuel growth and hence to sell land – had led to “an ecological crisis”, in which heavily-polluting factories have blighted the environment.

Think local, act local…

Tax policy drives local government thinking, and sometimes disobedience too. In last week’s issue we cited the example of Benxi Steel, a mill that larger competitor Angang has been trying to merge with since 2005. The problem is that Benxi’s local government doesn’t want to relinquish ownership. One key reason: a merged entity will have its new headquarters in the city of Anshan, which will then be the sole beneficiary of local corporate taxes. Hence Benxi’s bureaucrats have fought against the merger, even though the central government has been trying to push through consolidation in the steel sector.

As this case shows, cities have a vested interest in attracting corporate headquarters, since they then benefit from the local taxes they pay. That’s also why being a ‘financial centre’ has such appeal. They are not only a magnet for corporate HQs, but the service industries that congregate close by tend to be greater payers of local taxes such as business tax and land use taxes.

That explains why no fewer than 26 cities in China are currently building financial centres (see WiC50). It’s also why China’s foremost financial centre – Shanghai’s Lujiazui district – is offering a special rebate to persons deemed to have special banking ‘talents’. Such rebates substantially reduce the individual’s personal income tax rate. But the local government is counting on it making Lujiazui a more attractive location for an HQ – and thus garnering all the ancillary taxes that status derives.

Tax also explains why cities, and regions, are so keen to lobby the central government for special economic zone status. In 2009 the State Council approved 14 such zones – including the Anhui Urban Belt and the Gansu Circulation Economic Zone. In recent weeks the State Council has also given approval for a new body called the Yangtze River Delta Planning Authority. These zones give local officials greater planning powers – and mean a lot less meddling from Beijing. The central government lightens the tax load in the zones, typically waiving corporate income taxes for businesses that set up in them. Moreover it agrees to stump up for key bits of flagship infrastructure (say, a high speed rail track). Banks are instructed to lend too, since the State Council has determined that the development zones are priority areas. That makes the property game even more lucrative. If you are an ambitious local official, it’s like running a mini-state (i.e. a near El Dorado for dishonest bureaucrats).

It got worse in 2009?

The central government had long known how the cities were driving much of their growth. But with the onset of the global financial crisis in 2008, it was desperate that the GDP figures show no sign of flagging. It therefore ordered a $586 billion stimulus package, with the tacit understanding that the banks and local governments would finance huge chunks of the infrastructure that it envisaged.

City governments saw this as a golden opportunity to finance their wish list of projects. The state banks happily lent to them – via shadowy entities called local government financing platforms. Banks assumed the lending was risk-free, since it was ultimately backed by the state (through local government guarantees). Estimates vary but the Chinese Academy of Social Sciences thinks that around Rmb5 trillion was raised via such financing platforms last year (there are 3,800 of them). Victor Shih, a professor with Northwestern University in the US, estimates a higher Rmb11 trillion sum. It’s equally difficult to work out how much of the bank lending has been splurged on projects which won’t make a return sufficient to cover debt repayments. But Shih reckons Rmb3 trillion, or $439 billion, could go ‘bad’ and will need to be written off by the banks.

If that’s the case, China’s municipal borrowers might have brewed up their local equivalent of the Greek debt crisis. Little wonder, then, that the banks are queuing to raise new capital. Bank of Communications was the latest to do so this week, raising $4.8 billion through a rights issue.

How to fix this mess?

Local government finances are the cancer at the heart of China’s financial system. And some experts say that the disease is approaching its terminal stage. After all, local government’s cannot sell land forever – it’s a finite resource. Nor can their development model function without bank loans – and bankers have already been told to scale back their exposure to the local government financing platforms.

So it looks like something has to give. A combination of a high-profile property bubble and rising concern from the Chinese banking regulator has forced the leadership in Beijing to consider overhauling the tax system for the first time since 1994. The goal: to make city governments less dependent on land sales.

So what are the options?

Local governments have long suggested that a municipal bond market might help. The central government is less keen, fearing the creation of a lot more local debt rather than a genuine solution to the funding problem.

Last month a new resources tax was announced, which will be tested in Xinjiang (see WiC62). This will see commodities such as oil and gas taxed on their value rather than their extraction volume. Analysts estimate the move could see the local government in Xinjiang increase its revenues by Rmb42 billion per year. However, a resources tax will only benefit a handful of provinces. In the case of Xinjiang it is also being seen as politically-inspired. After the ethnic riots last year, Beijing is keen to transfer more money there to speed development. Some commentators doubt it will be applied elsewhere in the country.

So the most likely fix is a property tax – charged as an annual percentage of the appraised value of a house or apartment, akin to the US system. As Wang at the Chinese Academy of Social Sciences told Hessler: “Stable income from property taxes could end the current system of real estate speculation.”

The Chinese media is reporting that the cities of Shanghai and Chongqing have both submitted plans for a property tax to the State Council. The advantages are obvious in creating a consistent revenue stream – and one that is hard for the property owner to avoid paying. It also makes it more onerous to buy multiple homes and apartments – and leave them empty – just for the purposes of speculation.

In the medium term a new property tax makes sense as a way of repairing local government finances and weaning officials off selling land. However, in the shorter term the fear is that such a tax could kill the real estate market and slow investment in new construction to a trickle. With the global economy apparently so fragile, the timing of such a move is far from ideal. A weaker property market will hit GDP growth, and that could create more non-performing loans for the banks.

So while it seems pretty evident that local government finances are at the heart of many of China’s problems, the current economic environment means that the central leadership is in a spot: damned if they do (that is, try to fix things with a property tax) but also damned if they don’t (try to muddle on through). Fortunately, China has some experience of muddling through. But if it doesn’t pull it off this time round the fallout could be far worse than anything we are seeing in Greece…

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