Written by Timna Michlmayr

The challenges in the real estate sector are rooted in an institutionalized financing system that China is unwilling – or unable – to depart from

China’s current economic situation remains inherently precarious. As exports and imports plummet, private consumption wanes, debts soar, and youth unemployment reaches such alarming levels that official figures are withheld from public scrutiny, the Chinese real estate sector is still in a true crisis. Although the default of the real estate company Country Garden was recently averted, a solution to underlying problems is still far off.

In the discourse surrounding China’s real estate crisis, it should be noted that the challenges plaguing the real estate sector are intertwined with fundamental institutions of China’s political-economic system, most notably the financing apparatus of local governments. Consequently, the crisis poses enormous challenges for the Chinese government.

Deep-Seated Structures

The real estate turmoil in China can be directly linked to the debt pressures faced by local governments. Given that a substantial portion of local governments’ income in China emanates from land sales, any deterioration in land and housing values inevitably results in a reduction of local revenue streams, consequently heightening the vulnerability to mounting debts. In the year 2022, the real estate sector witnessed a substantial decline, precipitating an alarming 23 percent drop in overall revenues generated from land transactions. This dire fiscal situation exerted such immense pressure on local government finances that they found themselves unable to meet their obligations, including the payment of salaries to public servants.

The entrenched financial reliance of provincial governments on the land market isn’t a novel phenomenon; instead, it’s a well-established developmental model that the Chinese government continues to uphold today. This model was cemented following the tax reform of 1994, which saw a significant portion of local government tax revenue redirected to the central government, while the responsibility for expenditure shifted to provinces. In order to redress the resultant fiscal imbalance, local governments resorted to leveraging income generated from the state-controlled land market, often selling land use rights to real estate companies at steep prices. Moreover, local governments were granted the ability to accumulate debt based on anticipated future land sales. In essence, the state has placed its bet on the prospect that forthcoming revenues from the land and real estate sectors will eventually pay off today’s debts.

This financial framework, often referred to as “land finance” (known as tudi caizheng in Chinese), has been a cornerstone of the Chinese economic growth model for a considerable duration. State-backed infrastructure investments found their financial footing in land sales and loans hinged upon anticipated future revenues from the land market, serving as catalysts for growth. Nevertheless, China’s heavy reliance on this “land-centric” approach has increasingly presented challenges. Particularly in the aftermath of the global financial crisis in 2008, an escalating portion of government debt became reliant on proceeds from the land market. This heightened dependency, especially during times of a dwindling real estate market, creates incentives for local governments to artificially stimulate demand in both the housing and land markets. For instance, since 2022, local authorities have resorted to purchasing their own land to artificially inflate land and property prices as a means to service their debts. Despite these pressing issues, Chinese leaders have refrained from overhauling the local government financing system, a model that has persisted for nearly three decades. Reform endeavors, when undertaken, have primarily addressed surface-level symptoms rather than delving into the fundamental structural challenges.

Challenging Reforms

The reluctance to pursue substantial reforms stems from the advantages inherent in the existing financing system when weighed against the drawbacks of its abolition. Undertaking a profound transformation would entail fundamental reforms of the Chinese political-economic system.

To embark on this path, it becomes imperative to reconfigure the distribution of revenue between the central and local authorities, thereby granting local governments a greater share of tax proceeds. However, this redistribution entails an undesirable relinquishment of fiscal authority and control by the central government. Additionally, the introduction of new taxes, notably a real estate tax, becomes a necessity to establish more sustainable revenue streams. Initial attempts at implementing such measures have been limited to select cities. The reform effort is also linked to concerns within the Chinese government about potentially harming the vested interests of homeowners.

Moreover, the overhaul would implicate a substantial revision of China’s cadre evaluation system, designed to prioritize the short-term economic achievements of local officials. This change might potentially dampen their incentives for investment. A comprehensive reform strategy could also encompass measures to curtail the monopoly held by local governments in the land market to forestall market distortions. Nevertheless, the notion of complete land privatization in China appears unlikely, as it runs counter to the fundamental principles of Chinese socialism.

Another pressing issue revolves around the responsibility for shouldering the mounting debts of local governments. It’s plausible to expect that the central government would step in to assist if local governments were to face bankruptcy, a scenario that could potentially have far-reaching consequences for the entire financial system. Nevertheless, one fact remains evident: as the real estate market crisis causes income to dwindle and local-level debt to rise, the burden of this debt continues to accumulate. In this context, adhering to established structures and resorting to short-term economic stimulus packages to avert prolonged crises in the real estate sector appears to be the more convenient course of action.

(When) Is a New Model Coming?

The consensus among most analysts studying China’s economic landscape is that extensive reforms of the local financing system are crucial to tackling enduring problems in the real estate sector. My recent research trip to China in June 2023, conducted as part of my dissertation, however, revealed an absence of concrete ideas for substantial reforms at present. While the term “transition” to a new model is on everyone’s lips, there appears to be a prevailing uncertainty about the ultimate destination of this transition.

Nonetheless, the more China prolongs the status quo, the less tenable the starting point for future reforms becomes. In the long run, it’s inevitable that China must shift its growth model, including the local financing system, toward one where the real estate market plays a less prominent role. While China’s capacity for “muddling through” should not be underestimated, it is now – also from the government’s perspective – time for genuine reforms.