China’s Consumption Slowdown: A Real Estate Slump and a Debt-Driven Dilemma
China’s economic growth has been a major driver of the global economy for decades. But in recent years, the country has been grappling with a persistent consumption slowdown, a development that has a multitude of causes, but the primary source of this slowdown may be traced back to the country’s real estate slump and the deep entanglement between this slump and local government finances, particularly their elevated debt levels. While local governments have implemented measures to address the situation, experts are increasingly concerned about the long-term implications of this intertwined crisis.
Key Takeaways:
- China’s real estate decline is hurting local government finances: The bulk of Chinese household wealth has been invested in real estate over the past two decades, but a government crackdown on speculative developers has led to a decline in property values and a reduction in land purchases. This in turn has severely impacted local government revenue, especially at the district and county level, which is a major source of income for the local government.
- Local authorities are trying to claw back revenue: Local governments in China are resorting to aggressive tactics to recoup tax revenue, including demanding back taxes from businesses for activities dating back to 1994. This has sparked outrage among businesses and intensified uncertainty about future income for consumers, contributing to the consumption slowdown.
- Investment-driven growth is unsustainable: While China has traditionally relied on investment to fuel economic growth, experts are increasingly concerned about the sustainability of this approach, particularly in the context of rising debt levels. A shift towards consumption-driven growth is necessary, but this transition poses significant challenges for the government.
- Local government financing vehicles (LGFVs) pose a major risk: The complex web of LGFVs, which are government-affiliated entities that have borrowed heavily to fund infrastructure projects, represent a much more substantial risk to the financial system than the troubled real estate sector.
- The challenges are complex and require a coordinated approach: Experts point out that the problems facing China’s local governments are intricate and require careful policy adjustments, but the government lacks the resources to address them all at once. The situation emphasizes the need for a concerted effort from both the central and local governments to stabilize the financial system while nurturing a more sustainable economic model.
The Real Estate Slump’s Impact on Local Government Finances
The real estate sector in China has long been a crucial driver of economic growth. However, in 2020, the government began a crackdown on rampant speculation and developers’ high reliance on debt. This crackdown has had a significant impact on both the real estate market and the finances of local governments. As property values have declined and developers have reduced land purchases, local governments have experienced a substantial drop in revenue, leaving them with limited resources to fund essential services and infrastructure projects.
"The financial accounts of local governments have suffered from the drop in land sales revenue for at least two or three years, while tax and fee cuts since 2018 have reduced operating revenue by an average of 10% across the country." – Wenyin Huang, Director at S&P Global Ratings.
While local authorities have taken steps to diversify their revenue streams, these efforts have not fully offset the losses from declining land sales. This has left local governments in a precarious financial position, and their struggle to generate sufficient revenue has contributed to the overall economic slowdown.
Clawing Back Tax Revenue: A Desperate Measure?
Faced with dwindling revenue, local governments in China have resorted to aggressive tax collection measures. This includes demanding back taxes from businesses for activities dating back to 1994. Businesses have been forced to disclose in stock exchange filings the amounts they are being asked to repay, with some companies reporting amounts ranging from 10 million yuan to 500 million yuan ($1.41 million to $70.49 million). These notices cover a wide range of tax obligations, including unpaid consumption taxes, undeclared exported goods, late payment fees, and other fees.
"Revenue is the key issue that should be improved… They cannot cut down [on spending] unlike the expenditure for land development." – Laura Li, Sector Lead for S&P Global Ratings’ China Infrastructure Team.
While the Chinese government has denied allegations of a nationwide tax crackdown, the aggressive pursuit of back taxes has caused an uproar among businesses and has damaged already fragile business confidence. The move is seen by many as a desperate attempt by local governments to shore up their finances, even at the expense of further dampening consumer spending and economic growth.
The Dilemma of Shifting Gears: From Investment to Consumption
While local governments scramble to recoup revenue, the larger issue remains: how to stimulate economic growth in a way that is both sustainable and not reliant on heavy investment. This has become a challenging task, especially given the government’s commitment to reducing debt levels and its long-standing dependence on investment as a primary engine of growth.
"What is overlooked is the fact that investment is creating weak nominal GDP growth outcomes —pressuring the corporate sector to reduce its wage bill and leading to a sharp rise in debt ratios." – Morgan Stanley chief Asia economists Chetan Ahya and Robin Xing.
The government’s attempts to shift from investment-led growth to consumption-driven growth have been met with limited success. Experts argue that the longer this transition is delayed, the more likely it is that the government will be forced to ease its strict financial controls to prevent a further slowdown in growth and a potential loss of control over inflation and property prices.
The Hidden Threat of Local Government Financing Vehicles (LGFVs)
Beyond the impact on local government finances, the debt-driven infrastructure boom has fueled the growth of LGFVs. These government-affiliated entities play a significant role in financing infrastructure projects, often with limited financial returns. These entities are known as "grey rhinos," a metaphor for high-likelihood, high-impact risks that are being overlooked.
"The ‘grey rhino’ for banks — nobody knows if there is an effective way that can solve this issue quickly." – Laura Li, Sector Lead for S&P Global Ratings’ China Infrastructure Team.
The exposure banks have to LGFVs far exceeds their exposure to real estate developers and mortgages, posing a potential threat to the stability of the financial system. While the government has taken steps to address the immediate liquidity challenges posed by LGFVs, experts acknowledge that the resources to fully resolve this problem are limited.
A Path Forward?
The economic challenges facing China stem from a complex interplay of intertwined issues, including the real estate slump, the financial health of local governments, the need to shift to a more sustainable growth model, and the risk posed by LGFVs. Experts acknowledge that a coordinated approach, involving both the central and local governments, is crucial to address these issues. The solutions will need to be multifaceted, balancing the need to stabilize the financial system with the need to nurture long-term sustainable growth.
The future of China’s economy hinges on its ability to adapt to this new reality. Navigating the challenges of slowing growth, elevated debt levels, and the evolving role of the real estate sector will require strategic policy adjustments, a commitment to transparency, and a renewed focus on fostering a robust consumer market. The outcome of this challenging period will have global repercussions, as China’s position in the world economy continues to evolve.
