China is experiencing a consumption slowdown due to the country’s real estate slump and its impact on local government finances and debt. The decline in property values and reduced land purchases by developers have severely affected local government revenue, particularly at the district and county levels. It is estimated that it will take three to five years for local government finances to recover to a healthy state. This slowdown in revenue has been exacerbated by tax and fee cuts since 2018, leading to uncertainty among consumers about future income.
Local authorities in China are actively trying to recover revenue, resulting in businesses being audited for potential tax missteps dating back to decades. This has caused distress among companies, leading to a decline in business confidence. The pressure to recoup taxes from past years showcases the government’s desperation to find new sources of revenue. The national taxation administration has defended these measures as routine and in accordance with the law, dismissing claims of widespread investigations or retrospective tax hunts.
The focus on reducing debt levels has made it challenging for Chinese authorities to shift policy towards growth driven by consumption. Efforts to prioritize investment have led to weak nominal GDP growth outcomes, putting pressure on the corporate sector to reduce wage bills and increasing debt ratios. Delays in pivoting towards consumption-driven growth could result in a loss of control over inflation and property price expectations, ultimately leading to higher debt-to-GDP ratios. The current debt-to-GDP ratio in China stands at 310% and is expected to increase further to 312% by the end of the year.
One of the major challenges in China’s financial system is the complex interconnection of local government-affiliated business entities known as local government financing vehicles (LGFVs). These entities have accumulated significant levels of debt to fund public infrastructure projects with limited financial returns. Chinese banks are more exposed to LGFV loans than those of real estate developers and mortgages, posing a significant risk. The government is strategizing to buy time to address the liquidity challenges posed by LGFVs while maintaining overall stability in the financial system.
The persistence of China’s consumption slowdown is deeply linked to the real estate sector’s decline and its impact on local government finances and debt. The revenue-generating power of local governments has been hampered by macroeconomic headwinds, particularly in land sales, taxes, and fees. Reforms to boost revenue and recover taxes from years past have further intensified the economic challenges facing businesses and consumers. As China grapples with these issues, finding a balance between debt reduction, revenue recovery, and sustainable growth remains a critical task for policymakers and financial institutions.
