The debt problems of Chinese local governments are a hidden brake on economic growth

BEIJING – China’s ongoing consumption slowdown can be traced to the country’s real estate crisis, as well as 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 developers’ heavy reliance on debt in 2020.

Now the value of these properties is falling and developers have reduced land purchases. That makes a significant difference to local government revenues, especially at the district and provincial level, according to analysts at S&P Global Ratings.

They predicted that from June this year it will take three to five years for the local government’s finances to be healthy again.

But “delays in revenue recovery may prolong efforts to stabilize debt levels, which continue to rise,” Wenyin Huang, managing director of 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, especially when it comes to taxes and land sales,” she said.

Huang had previously told CNBC that local governments’ financial accounts have been suffering from the drop in land sales revenue for at least two or three years, while tax and fee cuts since 2018 have boosted corporate revenues across the country by an average of 10% reduced.

This year, local authorities are scrambling to recoup revenues, leaving already under-pressure businesses with little reason to hire or increase salaries – and increasing consumers’ uncertainty about future income.

As officials pore over historical data on possible corporate and government missteps, dozens of companies in China disclosed in stock market filings this year that they had received notices from local authorities as early as 1994 to repay taxes related to their operations.

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

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

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

The development has caused a stir online and damaged already fragile business confidence. Since June 2023, the CKGSB Index of operating conditionsa monthly survey of Chinese companies, hovers around the 50 level, indicating contraction or expansion. The index fell to 48.6 in August.

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

The push to recover taxes from years ago “really shows how desperate they are for new sources of revenue,” Camille Boullenois, deputy director at Rhodium Group, told CNBC.

The Chinese National Tax Administration in June acknowledged that some local governments had made such notices, but said they were routine measures “in line with laws and regulations.”

The government denied allegations of “nationwide, sector-wide, targeted tax inspections” and said there is no plan to “retroactively” investigate unpaid taxes. This is evident from the translation of the Chinese text by CNBC on the government website.

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

“Many government expenditures are so-called necessary expenditures,” such as education and civil servant salaries, she said. ‘They can’t cut back [on it] as opposed to land development spending.”

A simple way to increase sales 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 growth driven by consumption, analyst reports show.

“What is being overlooked is the fact that investment is driving weak nominal GDP growth outcomes – putting pressure on the corporate sector to reduce labor costs and leading to a sharp increase in debt ratios,” said Chetan Ahya and Robin Xing, Morgan Stanley’s chief economist in Asia. September report, together with a team.

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

The economists pointed out that similar efforts to deleverage between 2012 and 2016 also dampened growth, ultimately pushing up the debt-to-GDP ratio.

“The same dynamics are playing 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 will rise further to 312% by the end of this year, according to Morgan Stanley.

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

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

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

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

Natixis’ research shows that Chinese banks are more exposed to loans from local governments than to real estate developers and mortgages.

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

“What the government is trying to do is buy time to resolve the most looming liquidity problems so that they can still maintain the overall stability of the financial system,” she said. ‘But at the same time the central and local government[s]they don’t have enough resources to solve the problem all at once.”