In cities and towns across China, up to 80 million properties sit vacant – the cumulative result of decades of overbuilding driven by speculative demand that is now exacerbating the parlous state of the country’s provincial economies.
Provincial government land markets and local government financing vehicles (LGFVs) may seem arcane and far removed from global trade. But in reality, they have served as the edifice upon which China’s now slowing investment-led growth model has been built.
The idiosyncrasies of China’s political economy and fiscal composition mean that much of this investment has been driven by local governments.
With Beijing deeply reluctant to embrace consumption-led growth alternatives, leaders are betting on exports to take up a much larger share of the slack. China invests about 45 per cent of its GDP – an unprecedented figure for any modern economy. Until recently, infrastructure and property have routinely each comprised about 30 per cent of this total. The idiosyncrasies of China’s political economy and fiscal composition mean that much of this investment has been driven by local governments.
In simple terms, LGFVs are off-balance financing vehicles used by local governments to circumvent restrictions on issuing conventional bonds. Their existence has been tacitly tolerated by Being after fiscal recentralisation reforms in 1994 left local governments responsible for 85 per cent of general budgetary spending while receiving typically less than half of fiscal revenue.
To maintain services provision while meeting aggressive growth targets, local governments have become reliant on non-tax funding – i.e., LGFVs and land sales. The latter constituted 42 per cent of local governments’ general public budget revenue in 2021 – a figure that is still above 20 per cent.
LGFVs played an essential role in funding China’s colossal infrastructure buildout, which has also helped drive up land prices in what was previously a virtuous growth cycle. In the heady days before China’s real estate collapse, land revenue provided an ostensibly inexhaustible source of largesse for subsidies.
This growth model was not without its drawbacks. After decades of bingeing, LGFV debt comprises well over half of China’s GDP – a totally unsustainable dynamic when median return on assets has hovered around one per cent. Local governments are now spending around 19 per cent of total fiscal resources on interest payments.
Policy changes promulgated by Beijing, while likely salutary in the longer term, will place further downwards pressure on growth.
Earlier this year, Beijing drastically restricted the ability of the 12 most indebted provinces and municipalities (whose cumulative investment comprised 16 per cent of China’s total in 2023) to tap LGFVs for infrastructure spending. Investment in these regions is expected to decline by around one-quarter this year. Restrictions of varying severity have been placed on 18,000 LGFVs across China.
Efforts to resuscitate the flagging real estate market will also further constrain provincial finances. To lance the boil of oversupply, a land sale moratorium has been introduced in cities with unsold housing inventories equivalent to more than three years of sales.
This will affect at least 40 per cent of China’s largest cities – with some cities having backlogs of up to a decade.
China’s overcapacity has proved corrosive to the industrial ambitions of lower and middle-income countries.
Pointing to China’s anaemic private consumption rates, economists have long advocated boosting growth through measures such as expanding China’s parsimonious social safety net. Despite paeans to “common prosperity”, Beijing has shown little inclination to do this.
For one, the reforms required to reorient China’s economy towards consumption are replete with political risk and complexity – even for the most centralised administration since 1976. There also exists a more ideological aversion to “welfarism” and the perceived consequences of Western-style consumption including inflation, deindustrialisation and the rise of inordinately powerful corporate fiefdoms.
Beijing’s reticence to boost consumption and the inexorable deceleration of its traditional growth drivers – including the money supply that feeds them – have implications for its trade posture.
Chinese leaders definitely see strategic utility in ensuring that G7 nations are reliant on China for critical technologies. Yet, with most of China’s population still poor by advanced economy standards, this dynamic can be over-egged when explaining China’s export overcapacity and aggressive push into Western markets.
With other growth drivers exhausted or off the table, the leadership of central governments – and the ferociously competing provinces – see little alternative but to externalise weak domestic demand. Rather than a tightly controlled masterplan, the causal weighting lies more towards an uncoordinated, desperate push for growth.
This is unlikely to provide much solace for G7 manufacturers. Nor does it augur well for current attempts in the European Union to negotiate managed trade deals on electric vehicles – a la the export discipline agreements negotiated with Japan in the 1980s.
While Beijing might tolerate more auto investment in Europe, the central government and the provincial governments undergirding China’s export champions have every incentive to keep most jobs onshore.
China’s overcapacity has proved corrosive to the industrial ambitions of lower and middle-income countries. Rather than offshoring more labour-intensive industries as has been hoped, President Xi has called for the “transformation and upgrading of traditional industries”. Chinese manufacturing imports from these countries have declined appreciably.
While the prospect of a course correction should not be discounted out of hand, China looks set on the path towards ever greater trade confrontation.
