Local governments in China are still building highways, bridges and railways, as seen here in Jiangxi province on September 6, 2024.
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BEIJING — The ongoing decline in Chinese consumption is due to the sluggishness of the country's real estate market and its strong interdependence with local government finances and debt.
The majority of Chinese household wealth flowed into real estate over the past two decades before Beijing began cracking down on developers' high levels of leverage in 2020.
Now the values of these properties are falling and developers are buying less land. This is leading to significant losses in revenue for local authorities, especially at the district and county levels, according to analysts at S&P Global Ratings.
They have been predicting since June this year that it would take three to five years for local government finances to return to a healthy state.
But “delays in the recovery of government revenues could slow 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 impact the revenue opportunities of China's local governments, particularly related to taxes and land sales,” she said.
Huang had previously told CNBC that local governments' financial accounts have been suffering from a decline in revenue from land sales for at least two or three years, while tax and fee cuts since 2018 have reduced operating revenues across the country by an average of 10%.
This year, local authorities are working hard to boost government revenues, giving already struggling businesses little reason to hire new staff or raise salaries, and increasing consumers' uncertainty about their future income.
Reclaiming tax revenue
While Chinese authorities have a history of investigating possible missteps by companies and governments, this year dozens of Chinese companies disclosed in stock exchange filings that they had received demands from local authorities to pay back business-related taxes as early as 1994.
They reported amounts ranging from 10 million to 500 million yuan ($1.41 million to $70.49 million), covering unpaid consumption taxes, undeclared exported goods, late payment fees and other charges.
Even in the relatively prosperous eastern province of Zhejiang, NingBo BoHui Chemical Technology said regional tax authorities in March ordered the company to repay 300 million yuan ($42.3 million) in revised consumption taxes due to a “recategorization” of aromatic derivatives extraction equipment produced since July 2023.
Jiangsu, Shandong, Shanghai and Zhejiang – some of the provinces with the highest tax and non-tax revenues – are seeing 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, especially as its other major sources of income face increasing challenges.”
The development has caused an uproar online and damaged already fragile business confidence. Since June 2023, the CKGSB Business Conditions Index, a monthly survey of Chinese companies, has been oscillating around the 50 mark, which indicates economic slowdown or expansion. In August, the index fell to 48.6.
Retail sales have recovered only slightly from their lowest level since the Covid-19 pandemic.
The pressure to recoup taxes from years ago “really shows how desperate they are for new sources of revenue,” Camille Boullenois, deputy director of the Rhodium Group, told CNBC.
While the Chinese tax authority acknowledged in June that some local governments had issued such notices, it said these were routine measures “in accordance with laws and regulations”.
The government denied the allegations that there were “nationwide, industry-wide, targeted tax audits” and said there were no plans to “investigate unpaid taxes retrospectively,” according to CNBC's translation of the Chinese text on the government website.
“Revenue is the main issue that needs to be improved,” Laura Li, sector head of S&P Global Ratings’ China infrastructure team, told CNBC earlier this year.
“A lot of government spending is so-called necessary spending,” such as education and civil servant salaries, she said. “You can't cut [on it] as opposed to spending on land development.”
Debate on growth impulses
One easy way to increase government revenue is through growth, but with Chinese authorities prioritizing debt reduction, it is difficult to shift policy from a long-standing focus on investment to consumption-led growth, analyst reports show.
“What is overlooked is the fact that investment leads to weak nominal GDP growth – forcing the corporate sector to cut its labor costs and leading to a sharp increase in debt ratios,” Chetan Ahya and Robin Xing, chief Asia economists at Morgan Stanley, said along with a team in a September report.
“The longer the turnaround is delayed, the louder the calls for easing to prevent losing control of inflation and house price expectations,” they said.
The economists pointed out that similar debt relief efforts in the years 2012 to 2016 also led to a slowdown in growth and thus ultimately pushed up the debt ratio.
“The same dynamics are playing out in this cycle,” they said. Since 2021, the debt ratio has risen by nearly 30 percentage points to 310 percent of GDP in the second quarter of 2024 – and is expected to rise further to 312 percent by the end of this year, according to Morgan Stanley.
They added that GDP was expected to rise by 4.5 percent year-on-year in the third quarter, “departing” from the official target of growth of around 5 percent.
The “grey rhinoceros” for banks
Major political change is difficult, especially in China's rigid, state-dominated system.
This investment-oriented focus is based on a complex network of local, state-owned companies that have taken on significant debt to finance public infrastructure projects that often yield only limited financial returns.
The sector, known as a financing vehicle for local governments, is a “bigger grey rhino than the real estate sector, 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 overlooked.
Natixis' research found that Chinese banks are more dependent on loans to local government financial vehicles than on loans to real estate developers and mortgages.
“Nobody knows if there is an effective way to solve this problem quickly,” S&P’s Li said of the LGFV problems.
“The government is trying to buy time to resolve the most pressing liquidity problems so that it can maintain the overall stability of the financial system,” she said. “But at the same time, the central government and local authorities must[s]they do not have sufficient resources to solve the problem immediately.”