China's sluggish property market presents a lingering headache. The pain is acute for the local and regional governments (LRGs) that rely on property sales. The central government is in a bind, too, for its economic recovery hinges on policy planning and execution by the LRGs.

The governments will struggle to achieve fiscal consolidation as long as investment-driven stimulus remains the chief means of spurring local development.

Direct Fiscal Effect From Slow Property Revenues Is Cyclical

Land sales remain the main source of fiscal revenue for most LRGs. We do not expect the sector's land sales to increase in 2023; and they are likely to rise by only 5% in 2024, given the tepid demand from domestic developers. This compares with a decline in land sales of 23% in 2022. LRGs' revenues are highly dependent on land sales and property-related taxes. Together these account for about 30%-35% of total revenues of the LRG sector (see chart 1).

Chart 1

However, slow land sales have a largely cyclical effect on the fiscal results of most LRGs. Revenue from land sales reflect a government's collection of land releases to the public (mainly developers), and an LRG spends to develop preliminary infrastructure (e.g., road, utilities, pipelines) on a parcel of land before release. A build-and-transfer model over the land projects largely minimizes losses (or deficits) for most governments, which use cash accounting to book revenues and spending.

A weakening in demand for new land projects will cause a proportionate fall in the costs of new land development (see chart 2).

Chart 2

Additional Spending Stimulus To Sustain Growth Is Structural

Slow land sales nevertheless indicate tepid development of the local economy (see chart 3). Policy easing in the domestic property sector since December 2022 has mitigated a sharp correction of the property sector that began in early 2023. However, it will take time for the recovery benefits to take effect.

Chart 3

China remains investment-driven. It increased infrastructure investment throughout 2022 to offset weak property investment. This allowed it to achieve GDP growth of 3% (see chart 4). LRGs' stimulus, either through their own budget or their key state-owned enterprises (SOEs), remains a catalyst to promoting local infrastructure activities, in our view.

Chart 4

We anticipate only a mild improvement of the LRG sector's deficit level, considering the need for ongoing fiscal stimulus to ensure a sustainable recovery. All 31 Chinese provinces except four (Beijing, Jiangsu, Qinghai, and Tianjin) set their 2023 real GDP growth target above the 5% national target announced at the National People's Congress.

The LRG sector reported a widening deficit level at 17% for 2022, compared with 11% in 2021. This followed another run of expansionary fiscal measures during China's efforts to contain the pandemic and deal with the property slowdown.

Top Cities Will Take An Uneven Approach To Stimulus

Lower-tier governments (mainly fiscally tier 2 and tier 3) appear more dependent on property activities. We estimate land revenues account for 4% of 2022 total revenues of provincial (tier 1) governments, 26% for city (tier 2) governments, and 38% for county (or tier 3) governments. This compares with 24% of the entire LRG sector at the same time.

The level of dependence on and correction of the domestic property market suggest that the location of LRGs remains the key to their risk profiles (see chart 5). For the purposes of this research, we have selected top cities from the scope of four municipality cities, five special planning cities and 27 capital cities, which have released 2022 main macro and fiscal data for domestic peer comparison.

Chart 5

The effect of the property slowdown on LRGs will continue to be uneven. Cities that are highly dependent on property but face a slow recovery are likely to continue stimulus. This includes additional borrowings by LRGs or their SOEs to sustain local growth (largely group B and group C in chart 6).

The viability of such an approach will, however, depend on policy scrutiny over highly indebted regions (see "China's Local Governments Are Shedding Their Ties To Struggling SOEs," published March 1, 2023).

Only a select group of cities, usually high-income cities supported by a more resilient economic structure, (largely Group A in chart 6) can continue their fiscal discipline, in our view. This includes an ability to tolerate a temporary slowdown.

Chart 6

LRGs that take more counterbalancing measures to sustain local growth will face a further rise in indebtedness. There are factors that might mitigate this, however. They include the Chinese government's tighter grip on new borrowings by LRG or their SOEs, a side-effect of which could be a local slowdown.

Ultimately, the tail risks of these LRGs are unlikely to alter China's policy direction. We believe their aggregated economic scale remains small. We doubt it will therefore delay the government's fiscal consolidation or growth.

Appendix

Table 1

Writer: Lex Hall

Related Research

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• China Property Watch: Peripheral Pain, May 22, 2023
• Credit FAQ: What The "Two Sessions" Say About Chinese Government Finances, March 19, 2023
• China's Local Governments Are Shedding Their Ties To Struggling SOEs, March 1, 2023
• The Clock Is Ticking For The Debt-Led Growth Of China Local Governments, Feb. 21, 2023
• China Cities Diverge To Navigate Property Slowdown, Nov. 1, 2022
• China Property Strains Will Roll Off Local Governments, And Land On Their SOEs, Nov. 10, 2021