China’s local government debt problems are a hidden drag on economic growth

BEIJING — The persistent slowdown in China’s consumption stems from the country’s real estate slump and its deep ties to local government finances and debt.

Most of Chinese household wealth has gone into real estate over the past two decades, before Beijing began to clamp down on developers’ high reliance on debt in 2020.

Now those property values ​​are falling and developers have cut back on land purchases. This significantly reduces local government revenues, especially at the district and county levels, according to S&P Global Ratings analysts.

They predicted that as of June this year, local government finances would take three to five years to return to a healthy state.

But “delays in revenue recovery could prolong attempts to stabilize debt, which continues to rise,” Wenyin Huang, director at S&P Global Ratings, said in a statement to CNBC on Friday.

“Macroeconomic headwinds continue to hamper the revenue-generating power of China’s local governments, particularly in taxes and land sales,” she said.

Huang previously told CNBC that the financial accounts of local governments have suffered from falling revenue from land sales for at least two or three years, while tax and tax cuts in 2018 have reduced operating income by an average of 10 % throughout the country.

This year, local governments are scrambling to recover revenue, giving already strained businesses little reason to hire or raise wages — and add to consumer uncertainty about future incomes.

As officials sift through historical records of potential corporate and government missteps, dozens of companies in China disclosed in stock market filings this year that they had received notices from local authorities to refund taxes related to operations as far back as 1994.

They declared amounts ranging from 10 million yuan to 500 million yuan ($1.41 million to $70.49 million), covering unpaid consumption taxes, undeclared exported goods, late fees and other charges.

Even in the relatively wealthy eastern province of Zhejiang, NingBo BoHui Chemical Technology said regional tax authorities in March ordered it to repay 300 million yuan ($42.3 million) in revised consumption taxes, as following a “recategorization” of aromatic derivatives extraction equipment. produced since July 2023.

Jiangsu, Shandong, Shanghai and Zhejiang – some of China’s top tax and non-tax revenue generating provinces – are seeing non-tax revenue growth surpassing 15% year-on-year growth in the first half of the year 2024, S&P’s Huang said. “This reflects the government’s efforts to diversify its revenue streams, especially as the other major sources of income face increasing challenges.”

The development caused an online uproar and damaged already fragile business confidence. As of June 2023, the CKGSB Business Conditions Index, a monthly survey of Chinese companies, has hovered around the 50 level indicating contraction or expansion. The index fell to 48.6 in August.

Retail sales rose only modestly from the slowest levels since the Covid-19 pandemic.

The pressure to recover taxes from years ago “really shows how desperate they are to find new sources of income,” Camille Boullenois, associate director at Rhodium Group, told CNBC.

China’s National Tax Administration acknowledged in June that some local governments had issued such notices, but said they were routine measures “in accordance with law and regulations.”

The administration has denied allegations of “nationally targeted, industry-wide tax audits” and said there is no plan to “retrospectively investigate” unpaid taxes. That’s according to CNBC’s translation of the Chinese text on the administration’s website.

“Revenues are the key issue that should improve,” Laura Li, sector leader for S&P Global Ratings’ China infrastructure team, told CNBC earlier this year.

“A lot of government spending is a lot of so-called necessary spending,” such as education and civil servant salaries, she said. “They can’t deduct (it), unlike land development expenditures.”

A simple way to increase revenue is to grow. But as Chinese authorities prioritize efforts to reduce debt levels, it has been difficult to shift policy from a years-long focus on investment to consumption-led growth, analysts report.

“What is being overlooked is that investment is creating weak nominal GDP growth results – putting pressure on the corporate sector to reduce their wage bill and leading to a sharp rise in the debt ratio,” said Morgan Stanley’s chief economists Chetan Ahya and Robin Xing in a statement. The report from September, together with a team.

“The longer the pivot is delayed, the stronger the calls will become for easing to prevent a situation where control over inflation and property price expectations is lost,” they said.

Economists have pointed out how similar deleveraging efforts from 2012 to 2016 also resulted in a drag on growth, ultimately driving the debt-to-GDP ratio higher.

“The same dynamic plays out in this cycle,” they said. Since 2021, the debt-to-GDP ratio has risen by almost 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 grow 4.5 percent from a year ago in the third quarter, “moving away” from the official growth target of about 5 percent.

Major policy changes are tough, especially in China’s rigid state-dominated system.

Underlying the focus on investment is a complex interconnection of local government-affiliated commercial entities that have taken on significant levels of debt to finance public infrastructure projects – which often have limited financial returns.

Known as local government financing vehicles, the sector is a “bigger gray rhino than real estate,” at least for banks, Alicia Garcia-Herrero, chief Asia-Pacific economist at Natixis, said during a webinar last week. The “gray rhinoceros” is a metaphor for high-probability, high-impact risks that are overlooked.

Natixis research has shown that Chinese banks are more exposed to loans to local government financial vehicles than to real estate developers and mortgages.

“No one knows if there is an effective way that can solve this problem quickly,” S&P’s Li said of the LGFV issues.

“What the government is trying to do is to buy time to resolve the most imminent liquidity challenges so that they can continue to maintain the overall stability of the financial system,” she said. “But at the same time, central and local governments do not have enough resources to solve the problem at once.”