Finance & Real Estate

Local Governments’ Revenue Squeezed Coming And Going–Defaults On The Horizon?

You have to pity local Chinese government officials. First, they piled up a load of debt. Then, the Central Government squeezes their biggest source of revenue to pay back the debt (or at least the interest). Next, the Central Government saddles them with a huge affordable housing that they are supposed to borrow more to pay for and that they have to give away land that they could have sold to pay debt. Did I also mention the economy’s slowing? The local government debt crisis may be back on the frontpages sooner than expected.

To get real estate prices under control, to slowly let the air out of a possible bubble, and to make housing affordable to more of the middle class, the Central Government is putting the squeeze on the real estate industry. And, it is having some success.

But, this success is also having an expected consequence: Local governments revenues are dropping fast.

China’s local government revenue, up to 80% in some places, comes from real estate. Here are two charts that capture this (I apologize that I don’t have the source at hand):

As real estate values go down, revenues from taxes drop. As fewer developers buy land, revenues from land sales drop (but local governments generally aren’t willing to cut prices to increase sales, so that there is a mismatch between housing prices and land prices that is also hurting sales).

Caixin online in ‘Governments in a Hole as Land Sales Plummet,’ reports:

The development-ready land market, long a reliable revenue source for local governments across China, has suddenly turned cold. And city halls are shivering.

Government-sponsored land auctions in cities nationwide have slowed dramatically in recent months, reflecting shrinking consumer demand and what one executive called a “winter mode” strategy among major developers. Nominal land values have fallen, and some auctions have been canceled due to a lack of bidders.

The article goes on to contend:

But local governments now face a dilemma. On the one hand, they see a need to control real estate prices, and would never dare disagree with or try to disrupt central government policies. But land sales have plunged, hurting their ability to pay for public services, ranging from police patrols to teacher salaries.

This misses two points. First, local government have for more than a thousand years disagreed with and disrupted ‘Central Government’ policies, and do so to this day with great abandon and ingenuity. More on this below.

Second, the problem goes far beyond paying for public services and salaries. The real problem is that local governments have accumulated acres of debt over the past several years, much of which they might not have been able to repay (or even pay the interest on) in the best of times. And, less so certainly as real estate revenues plummet. Consider:

As a brief aside regarding Caixin’s first point about local governments’ obedience to Central Government mandates, consider the contradictory policies that led local governments to rake up so much debt:

 Along these lines, I have full faith that if local government officials could find ways around the policies killing their revenues, they would do them in a heartbeat. Hey, they want to be promoted and shipping your old debts to the Central Government is not career enhancing.

But, just when local officials thought things couldn’t get worse, the Central Government comes up with its affordable housing program. A classic two birds, one stone.

First, construction makes up a large part of the GDP. The Central Government wants to slow down what I will call ‘for profit’ development. But, it still wants construction ticking along.

Second, home ownership and even just a decent place to rent is increasingly out of reach for most urban Chinese. Bad social policy and a threat to social harmony.

The solution:

The kicker for local governments. They are responsible for implementing the project. This includes borrowing more money (which lenders don’t want to lend) and giving away the land that the housing is build on. Here’s the cycle:

The upshot for local officials is that their balance sheets (the few complete ones that ever make it to Beijing) are weakened on both sides, with the increasingly likely result that they will default on the both the old and new debt, sending it to the Central Government’s balance sheet:

 

Did I also mention that the Chinese economy is slowing, that is, many, many local economies are slowing? Well, you can connect these dots and so can local officials. Expect sales of maotai at local government banquets to rise dramatically, or given the foregoing, make that beer, if they can afford it.

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  1. I’m not sure whether I am reassured or even more worried to learn the extent to which China’s local governments have made all the same mistakes that western governments and consumers made – over borrowed and spent beyond their means. On one hand, it starts to dispel the myth that China has all the assets and has the purchasing power to ‘take over’ the developed world. On the other hand, a local government debt crisis in China could undermine one of the few bright spots in the global economy.

    I was led to believe from reports however that Local Government bond sales were going well, as evidenced by the City of Shanghai’s recent bond auction ( http://bit.ly/uEQkWR ). While Shanghai may be a special case, is this not good news?

  2. Kevin Morrison writes on

    A “perfect storm” heading towards local Govt. money men. I can see some rolling heads in their future….

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