- China's district and county governments face growing credit risks. Sliding land revenue and a diminishing ability to issue more debt limit their budgetary capacity to support local economies and state-owned enterprises (SOEs).
- An ongoing decline in land sale values--a key source of revenue for this tier of local and regional governments (LRGs)--could erode their financial strength and diminish discretionary spending power. It will also force lower economic activity in property and land-related sectors.
- We are likely to see slower infrastructure spending from this tier, due to high borrowings. Fast debt growth from the tier is unlikely to continue over the next two to three years.
District and county governments are important cogs within the apparatus of Chinese government. They implement much of the central government's local policy agenda, and perform administrative functions such as welfare provision. They also undertake more than half of China's public sector capital spending, including primary land development. In this report, we refer to district and county governments as tier-three LRGs; see illustration below for China's local fiscal hierarchy.
Limited revenue recovery and constrained debt capacity will make it more difficult for this tier of LRGs to provide economic support to communities and SOEs. We expect their revenues to be harder hit by continued land sale declines than those of upper-level LRGs. Diminishing revenues will force them to curtail land development projects and will hurt local economic activities in related sectors. It will also limit discretionary spending on items such as subsidies and payments to business and local SOEs. The elevated debt risks that these LRGs accumulated during the COVID years will limit the scope of their further borrowing, making it harder to provide locally led infrastructure investment.
The growing risks are:
- Challenges to the economies of the LRGs;
- Still-large deficits in the near term; and
- Rising debt burdens, albeit at a slower pace.
These risks are not limited to tier-three LRGs. They could flow on to higher levels of government. For example, higher levels may feel pressure to provide support to tier-three LRGs' operations or even to make debt repayments in some stress situations. Upper levels may also need to shoulder more responsibility for local public spending.
Tier-three LRGs are hurting the most from the property slowdown
We expect China's tier-three LRGs to feel the most pain from China's continued land sales decline, with their greater reliance on land sales than that of tier one and tier two. Tier-three generally have fewer sources of fiscal revenue (including tax and fees, land sales revenue, and transfers from higher-level governments) than their upper-tier counterparts (see chart 1).
Due to the vast number of tier-two and tier-three LRGs in China, our analysis adopts proxy measures. We start from the data of 260 identified city governments in China, representing two-thirds of China's GDP. We make adjustments as needed to complete our estimates on tier-two metrics. We then aggregate data at the city-level and at the whole city level (including the city government's lower-tier governments), thereby reaching our estimates on tier-three metrics.
We believe China's land sales revenue is on track to extend its weak performance for the rest of 2023. Land sales dropped 20% year-on-year in January-July 2023 (see chart 2). This was driven by a number of factors. Foremost were low buyer confidence in the property market, which dampened demand; and a sluggish economy, which undermined consumer purchasing power for big ticket items such as apartments. The prospect of structurally lower land sales means tier-three governments are facing a significant revenue shortfall and therefore eroding financial capacity. In addition, current conditions affect property-related taxes--both transaction-based and recurring. Such property-related taxes are mainly collected by city, district, and county governments, i.e., tier-two and tier-three governments.
By contrast, the value-added taxes (VAT), another key source of LRG revenues, recovered robustly in the year to July 2023. This was due to a low base in 2022 with Chinese renminbi (RMB) 2.4 trillion of VAT reductions and refunds. Tier-one LRGs, whose operating revenues (including tax revenues and central government transfers) typically form the major share of their overall revenue than in the case of other tiers, are set to be the biggest beneficiaries of the LRG sector's operating revenue bounce.
We think tier-three LRGs will have to absorb the direct revenue shock from falling land sales mostly by themselves. Upper-tier government support for tier-three LRGs through transfer grants (including any support from the central government) will center primarily on operating activities. Therefore, tier-three LRGs are likely to get growing support for running their daily operations and services and providing social welfare. However, large scale transfers to support capital revenues, including land sale revenues, are unusual in China. The RMB599 billion that the central government provided in 2020 for infrastructure (part of the RMB 1 trillion special treasury issuance) was a rare exception.
Tier three pain presents a challenge for local economic recovery
The reduction in land revenue is likely to force tier-three LRGs to cut costs related to primary land development. Slack demand as a result of developers' lack of funds and the low economic incentive for them to purchase land parcels will contribute to this decision. In monetary terms, China's property investment dropped 8.5% year on year in January-July 2023.
We think the cost-cutting is achievable. The 23% drop in full-year 2022 land sales saw a commensurate drop in land development expenses. Therefore, it did not contribute to an overall revenue and expenditure imbalance (see chart 3).
While the reduction in land costs will help maintain budgetary balance, falling revenue from land sales is likely to have a number of negative consequences for tier-three LRGs. Their efforts to reduce land development expenses means they will reduce activities in land development, and in property-related projects. The resultant negative impacts on upstream and downstream activity could exacerbate the economic and social pain in tier-three cities.
In addition, under China's tougher risk controls, dropping capital revenue and growing non-discretionary spending items, such as fast-rising special purpose bond (SPB) interest obligations, will likely hinder tier-three LRGs' capacity to maintain other expenditure payments. China's district and county governments have seen rapid growth in debt over the past three years, leading to burgeoning interest payment obligations. While tier-three governments cannot directly issue LRG bonds, such funds are onlent from the issuing provinces.
LRGs prioritize interest payments. This will reduce their ability to make other payments, such as funds to SOEs for land-related project buybacks, support to SOEs in the form of rebates or subsidies, or support for economic recovery. As such, the tier-three LRGs that suffer most from land revenue shortfalls will have meager war chests to revive their economies.
Given the low prospects for a near-term land sales recovery, tier-three LRGs need to live within a new, tighter budgetary norm.
Constrained borrowing capacity limits the ability of tier-three LRGs to use infrastructure investment as an economic driver
Over the past few years, tier-three LRGs have grown direct debt at a faster rate than that of the other LRGs. They bolstered non-land local capex to combat China's initial COVID-related slowdown as well as to compensate for the country's regulatory dampeners on sectors including property of late (see charts 4, 5, and 6). We think the capex will have to slow down, given the tier's level of indebtedness relative to revenues. This could come at the expense of a local economic recovery.
Tier three governments have other sources of funding. Their key SOEs carry out important policy and financing functions on behalf of the government. The debts of tier-three key SOEs have grown faster than other SOEs in recent years, with the trend pre-dating the COVID pandemic (see chart 7). Their pace of debt accumulation is likely to slow over the next two to three years, given their very weak financial standing and the market's increasing scrutiny of the generally lower credit standing of their LRG owners compared to that of province-level or city-level governments (see charts 8 and 9).
We expect a moderation of borrowing growth by China's tier-three LRGs over the medium to long term due to the government's intention to stem the debt risks that have built up over the past years. Tier-three LRGs have the highest levels of debt among the tiers. Moderation will likely be achieved through lowering the amount of new special purpose bonds on-lent to this tier of LRGs, and slowing growth in debts held by district and county-level key SOEs.
China's policymakers are trying to balance the competing needs of near-term development against long-term financial stability. We expect high-risk LRGs--tier three LRGs represent the largest number in this category--will from now on play a smaller role in China's efforts to stimulate the economy. In our view, financial sustainability for high-risk tier-three LRGs is a priority for the central government. As policymakers juggle priorities, they will demand tighter financial discipline from these LRGs, while lower-risk LRGs will be given more room for expansion.
We think efforts to control the debt levels of the indebted tier-three LRGs will escalate over the mid to long-term, as China wobbles toward recovery after three years of pandemic. The central government may tactically adjust the pace of these debt constraints depending on factors such as the state of the economic recovery.
Credit risks accumulate at tier-three LRGs, representing contingent risks to upper-tier LRGs
Persistent revenue headwinds and borrowing constraints will likely put a growing number of tier-three LRGs in unfavorable economic positions, resulting in a negative impact on revenue. This will add to the credit risks of these local governments.
In the near term, weaker tier-three LRGs may run very high deficits and struggle to make ends meet. As a result, debt may keep rising, albeit at a slower pace than over the last three years. The weakening capacity of some tier-three LRGs to make timely debt repayments to upper-tier LRGs is a long-tail risk.
Upper-level governments are not ring-fenced from tier-three's risks. They may need to provide support to the tier-three LRGs' operations, or even make debt repayments on their behalf in stress situations. They may also need to shoulder more responsibility for local public spending. Under China's LRG framework, tier-three LRGs may get temporary liquidity support from tier-two LRGs. In the meantime, tier-one LRGs are the only eligible borrowers under the Budget Law, making it practically impossible for tier-two or tier-three LRGs to default even if they cannot meet debt payment obligations on time. In such situations, tier one, as official borrowers must make full repayments even if they on-lend much of the borrowings to lower-tier LRGs.
China usually focuses on system stability, in our view. Consequently, spillover from growing long-tail risks to the sector is unlikely.
Adj CapRev: Own capital revenue plus transfer inflows from government-managed fund accounts.
BACA %: Adjusted total revenue subtracted by adjusted total expenditure, as a percentage of adjusted total revenues.
DD: Direct debt.
DD onlent: Direct debt excluding that onlent to lower-tiers of governments.
Own OpRev: Operating revenues (excluding transfers),using data extracted from LRGs' general public budgets.
Short-term coverage: SOEs' cash and short-term securities measured against their short-term debt.
T1: Tier-one government and so on for T2 and T3.
TSD: Tax-supported debt.
TSD-onlent adj: Tax-supported debt excluding the debt onlent to lower-tiers of governments.
- Institutional Framework Assessment: Critical Local-Spending Responsibilities Still Weigh On Tier-Three LRGs' Fiscal Positions, Aug. 10, 2023
- Institutional Framework Assessment: China Provincial Governments' Capital-Light Framework To Support Fiscal Positions, Aug. 10, 2023
- Institutional Framework Assessment: China's Push To Delink LRGs From SOEs Relieves Some Pressure On Tier-Two Governments' Elevated Debt, Aug. 10, 2023
- What Are China's Options To Resolve Local-Government SOE Debt Risk?, Aug 3, 2023
- Economic Outlook Asia-Pacific Q3 2023: Domestic Demand, Inflation Relief Support Asia's Outlook, June 26, 2023
- Stimulus Is A Highwire Act For China's City Governments Facing Property Go-Slow, June 21, 2023
- China Local Governments: Balancing Growth And Risk, June 5, 2023
- Spending Sprees Will Subside As China Refines Infrastructure Investment, May 29, 2023
- Sector And Industry Variables: Institutional Framework Assessments For Local And Regional Governments Outside Of The U.S., March 22, 2023
- Economic Research: The Case For Cautious Optimism On China's Rebalancing And Openness, March 13, 2023
- China's Local Governments Are Shedding Their Ties To Struggling SOEs, March 2, 2023
- The Clock Is Ticking For The Debt-Led Growth Of China Local Governments, Feb. 21, 2023
- China's Trend Growth To Slow Even As Catchup Continues, Nov. 9, 2022
- China Cities Diverge To Navigate Property Slowdown, Nov. 1, 2022
- China LGFVs: Debt Control Will Outrank Infrastructure Stimulus In 2022, April 21, 2022
This report does not constitute a rating action.
|Primary Credit Analyst:||Wenyin Huang, Singapore +65 6216 1052;|
|Secondary Contacts:||Susan Chu, Hong Kong (852) 2912-3055;|
|Felix Ejgel, London + 44 20 7176 6780;|
|Research Assistant:||Chen Guo, Hong Kong|
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