The Link Between China's Property Market and Local Government Finances

Nicholas Borst (Federal Reserve Bank of San Francisco)



The importance of the property market to China’s investors, savers and banks is well known, but its impact on local governments is less well understood. The ability of Chinese local governments to service the debt they have built up over the past several years, 10.7 trillion RMB at the end of 2010, relies heavily upon the health of the property market.

China’s economic policymakers face a catch-22 when managing the real estate boom. If the housing bubble grows unchecked, systemic risks may endanger the entire economy. Conversely, government intervention that is too aggressive in deflating the housing market risks wrecking the finances of local governments. Accordingly, the government must walk a fine line when it comes to housing policy

The vulnerability of local governments to shifts in the property market stems from the importance of land fees and taxes to local government budgets. The issue of how to finance local governments has been a consistent source of tension in Chinese politics. In the decades immediately following China’s opening up, an increasingly large percentage of revenues were given to local governments. At the high point of fiscal decentralization, local governments claimed almost 80% of all revenues.

This fiscal model proved to be unsustainable and starting in 1994 it began to be reversed through a process of fiscal recentralization. Currently, there is a roughly even split in revenues between the central and local governments, with local budgetary revenues reaching 4.1 trillion RMB in 2010 (10% of GDP).

This even split in revenues, however, is not accompanied by an equivalent split in expenditures. The Lincoln Institute estimates that subnational governments in China account for 79% of government budgetary expenditures despite only receiving 47% of revenues. Local governments overcome this gap through additional transfers from the central government. In addition, local governments have large extra-budgetary and off-budgetary outlays, more than 3 trillion RMB in 2010, the vast majority of which are financed by land revenues.

Land in China is owned by the government, with usage rights granted to individuals and corporations through long-term leases. Local governments garner revenues from land through both taxes and fees. Local governments levy five different land taxes to bolster their budgets: an urban land use tax, a real estate tax, a land value-added tax, a farmland occupation tax, and a deed (land transfer) tax. The importance of land tax revenues have grown in conjunction with China’s booming housing market, going from less than 4% in 1999 of tax revenues to 20% in 2010.

Even more lucrative are the fees local governments charge when they lease land (i.e. sell land usage rights) to developers. Over the past decade, local governments have acquired massive amounts of land, often already occupied, and sold it to China’s booming property developers. This process has resulted in the displacement of millions of people and been a key source of social tension (the 钉子户 phenomenon).

Fees from land sales and leases are big business for local governments, reaching 2.7 trillion RMB and equivalent to 83% of budgetary tax revenues in 2010. Local governments love these funds because they are not included in the fiscal budget and are therefore relatively free from oversight. If both land taxes and land leasing fees are considered, land revenues were worth more to local governments in 2010 than the entirety of their budgetary tax revenues.

The vulnerability of local governments to swings in the property market should now be clear. A decline in land or property prices would reduce land tax revenues while a reduction in land purchases by developers could decimate land transfer fees.

A slowdown in the property market compromises the ability of local governments to meet their mounting debt obligations. Much of this debt went into financing infrastructure which will yield economic benefits in the long-term, but in the short-term will not produce sufficient revenue to service debt payments.

A slowdown in real estate could also reduce the high rates of local investment that have been so important to China’s rapid economic growth, further compounding the revenue problems of local governments.

In attempting to gently deflate the real estate market the central government is playing a very delicate game.

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