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

BEIJING — China’s persistent consumption slowdown can be traced back to the country’s housing crisis and its deep ties to local government finances and debt.

Most of Chinese household wealth went into real estate over the past two decades, before Beijing began cracking down on property developers’ high reliance on debt in 2020.

Now, property values ​​are falling and developers have cut back on land purchases. That’s significantly reducing revenue for local governments, especially at the district and county level, according to analysts at S&P Global Ratings.

They predicted that from June this year, local government finances will take three to five years to recover to a healthy state.

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

“Macroeconomic headwinds continue to hamper the revenue-generating capacity of local governments in China, particularly in relation to taxes and land sales,” he said.

Huang previously told CNBC that local governments’ financial accounts have suffered from falling revenue from land sales for at least two to three years, while tax and fee cuts since 2018 have reduced operating revenue by an average of 10% nationwide.

This year, local authorities are struggling to recover revenues, giving already-pressured businesses little reason to hire or raise wages and increasing consumer uncertainty about their future incomes.

As officials scour historical records for possible missteps by companies and governments, dozens of companies in China disclosed in stock exchange filings this year that they had received notices from local authorities to pay back taxes tied to operations dating back to 1994.

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

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

Jiangsu, Shandong, Shanghai and Zhejiang, some of China’s top provinces in terms of tax and non-tax revenue generation, are projected to see non-tax revenue growth of over 15% year-on-year in the first half of 2024, S&P’s Huang said. “This reflects the government’s efforts to diversify its revenue sources, particularly as its other major revenue sources face increasing challenges.”

The development has caused a stir on the Internet and damaged already fragile business confidence. Since 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 have only rebounded modestly from their slowest levels since the Covid-19 pandemic.

The push to claw back taxes from years ago “really shows how desperate they are to find new sources of revenue,” 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 line with law and regulations.”

The administration denied allegations of “national and sector-specific tax inspections” and said there are no plans to “retrospectively investigate” unpaid taxes, according to CNBC’s translation of the Chinese text on the administration’s website.

“Revenue is the key issue that needs to be improved,” Laura Li, sector leader of S&P Global Ratings’ China infrastructure team, told CNBC earlier this year.

“A lot of public spending is big so-called necessary spending,” such as education and civil servants’ salaries, he said. “They can’t cut back on it.” [on it] “unlike spending on territorial development.”

One easy way to boost revenue is through growth, but as Chinese authorities prioritise efforts to reduce debt levels, it has been difficult to shift policy from years of investment-focused growth to consumption-led growth, analyst reports show.

“What is being overlooked is the fact that investment is creating weak nominal GDP growth outcomes, putting pressure on the corporate sector to reduce its wage bill and leading to a sharp rise in debt ratios,” Morgan Stanley’s chief Asia economists Chetan Ahya and Robin Xing said in a September report, along with a team.

“The longer the shift is delayed, the louder the calls for easing will be to avoid a situation where inflation and property price expectations are lost control,” they said.

Economists noted that similar deleveraging efforts undertaken between 2012 and 2016 also resulted in a drag on growth, ultimately causing debt-to-GDP ratios to rise.

“The same dynamics are playing out in this cycle,” they said. Since 2021, debt-to-GDP has risen nearly 30 percentage points to 310% of GDP in the second quarter of 2024, and is projected to rise further to 312% by the end of this year, according to Morgan Stanley.

They added that GDP is expected to rise 4.5% from a year earlier in the third quarter, “moving away” from the official target of around 5% growth.

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

Behind this investment-focused approach is a complex interconnection of commercial entities affiliated with local governments that have taken on significant levels of debt to finance public infrastructure projects, often generating limited financial returns.

The sector, known as a funding vehicle for local governments, is a “bigger grey rhino than real estate,” at least for banks, said Alicia Garcia-Herrero, chief Asia-Pacific economist at Natixis, during a webinar last week. “Grey rhino” is a metaphor for high-probability, high-impact risks that are being overlooked.

Natixis research showed that Chinese banks are more exposed to loans for local government financial vehicles than to those of property 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’s problems.

“What the government is trying to do is buy time to resolve the most imminent liquidity problems, so that they can maintain the overall stability of the financial system,” he said. “But at the same time, the central government and local governments[s]They do not have sufficient resources to solve the problem immediately.”