Falling land sales will test the narrative of a recovering Chinese economy as local government finances creak under long-simmering strains, complicating attempts to shore up growth with an infrastructure investment boost. 

Although markets are celebrating signs of improving Chinese activity, better monthly data prints should not detract from the economy’s structural funding issues, which could weigh on growth, potentially creating fresh volatility for global markets. 

Land sales are essential to local governments, as transfers from the central budget have not been enough to keep the lights on. Land sales brought Rmb6.5tn ($970bn) into local government coffers last year, making up a record 27 per cent of total revenues. 

Revenues also flow in from property-related taxes, such as deed tax, which we estimate account for about 10 per cent of their fiscal take. (This does not include taxes applied more broadly, such as value added tax, nor those paid by ancillary industries to real estate, such as cement and steel.) 

With the health of local government finances inextricably tied to the country’s property markets, a real estate slowdown risks rippling out across the bureaucracy, making it more difficult for local governments to boost infrastructure investment to support the economy or to pay their bills. 

After more than two years of policy tightening, this crucial source of funding appears to be cooling, even as the leadership cuts spending and tightens fiscal budgets to allow for a Rmb2tn tax cut. 

Although  housing sales have rebounded after the lunar new year holiday, credit conditions remain tight and property developers have been much less active at land auctions. Land sales fell 34 per cent in the first two months of the year (data are amalgamated because the holiday falls on different dates each year), while the 5 per cent drop in local government revenues from land sales was the biggest since the economic turmoil of 2015. The main official economic indicators for the first quarter are scheduled for release on April 17.

The government is braced for a market slowdown, forecasting land sales growth of just 3 per cent in 2019, down from 25 per cent last year. This may be optimistic. In 2014, land sales grew 40.3 per cent in the first quarter before collapsing in the second half of the year. 

Land, lots of land

A fall in land sales could have a knock-on effect on infrastructure investment, which the leadership hopes this year will provide a glide path for economic growth to slow to a range of 6 to 6.5 per cent. If land sales fell 10 per cent this year — a not unthinkable scenario — that would mean around Rmb650bn less revenue for local governments. 

This is important for infrastructure spending because revenues from land sales can be used to capitalise infrastructure investment projects, unlike the  special purpose bonds that local governments are being encouraged to sell to raise funding for such investment. Minimum capital requirements for infrastructure projects are set at 20-25 per cent of total project funding, implying that a Rmb650bn drop in land sales revenues could affect as much as Rmb3.3tn in infrastructure investment. 

The government may lower capital requirements, as it did during previous downturns, but probably not by enough to ease project funding constraints.

Reduced revenues from land sales will make it harder for local governments to pay for things such as public services. Such revenues also help to service a debt load that the central government estimates at Rmb18.4tn, but which economists believe could be multiples of that. 

Ordinarily, central and local governments rely on surplus funds that can be carried over from previous years to fill revenue gaps. Although the source of such funds is murky, their size suggests that most comes from previous sales of land — Rmb1.23tn was carried over last year to meet the local government deficit target. As land sales fall and tax cuts bring in less revenue, reliance on such funding will have to increase to make up the shortfall. 

Unpalatable trade-offs

After a dismal start to the year, land sales may still rebound off the back of a relatively strong housing market in March. However, the risks are real of a continuing fall, which could force uncomfortable trade-offs if local governments are to avoid a funding crunch. 

A simple option to meet funding gaps and development targets would be an aggressive relaxation of restrictions on the housing market, stimulating supply and demand to increase the flow of funds to local governments. However, this is still politically unappetising because of the financial risks involved

Similarly, local governments may try to rely more on their corporate entities — local government financing vehicles, which were set up to bypass old deficit rules, and local state enterprises — though these are also under policy constraints and struggling with legacy debts from previous borrowing binges. 

The authorities may have to boost fiscal transfers to local governments, or show greater tolerance for financial failure in the provinces. The latter implies a risk of socio-economic upheaval, as city workers go unpaid or local government financing vehicles default. 

The risk of inaction by the centre is that local governments take the initiative to raise direct or indirect levies, which could dull the impact of the leadership’s much-hyped tax cuts. Not only could this slow economic growth; it also risks denting confidence in the central government’s policy programme. 

couple of decent PMI reads have managed to outweigh talk of a Chinese economic slowdown and cheer global markets. But the longer term issues plaguing Chinese growth have not been addressed and may continue to dog investors into 2019.

— He Wei, Financial Researcher, FT Confidential Research

FT Confidential Research is an independent research service from the Financial Times, providing in-depth analysis of and statistical insight into China and south-east Asia. Our team of researchers in these key markets combine findings from our proprietary surveys with on-the-ground research to provide predictive analysis for investors.