The local government debt issues in China are secretly hindering economic expansion.

• Analysts are examining the link between China's real estate market downturn and the financing practices of local governments in comprehending the slowdown in consumption.
• Wenyin Huang, director at S&P Global Ratings, stated that China's local governments are facing challenges in generating revenue due to macroeconomic headwinds, particularly in the areas of taxes and land sales.
• Morgan Stanley's chief Asia economists, Chetan Ahya and Robin Xing, stated in a September report that "investment is creating weak nominal GDP growth outcomes, which is pressuring the corporate sector to reduce its wage bill and leading to a sharp rise in debt ratios."

The slowdown in China's consumption can be traced back to its real estate market and the debt it has with local governments.

In the past two decades, the majority of Chinese household wealth was invested in real estate. However, in 2020, Beijing implemented measures to reduce developers' excessive use of debt.

The decline in property values and reduced land purchases by developers is significantly impacting local government revenue, particularly at the district and county level, according to S&P Global Ratings analysts.

It is predicted that it will take three to five years for local government finances to recover to a healthy state, starting from June of this year.

S&P Global Ratings' Wenyin Huang stated on Friday that prolonged attempts to stabilize debt could result from delays in revenue recovery, which continues to rise.

"Local governments in China are facing challenges in generating revenue due to macroeconomic factors, particularly in the areas of taxes and land sales," she stated.

Since 2018, local governments have experienced a 10% reduction in operating revenue due to tax and fee cuts, while the drop in land sales revenue has affected their financial accounts for at least two or three years, as previously stated by Huang to CNBC.

Local authorities are making efforts to recover revenue, putting additional pressure on businesses to hire or raise salaries, while also increasing consumers' uncertainty about their future earnings.

Clawing back tax revenue

This year, numerous Chinese companies revealed in stock exchange filings that they had been ordered by local authorities to repay taxes related to their operations dating back to 1994.

The range of amounts declared, which included unpaid consumption taxes, undeclared exported goods, late payment fees, and other fees, ranged from 10 million yuan to 500 million yuan ($1.41 million to $70.49 million).

In March, NingBo BoHui Chemical Technology was ordered by regional tax authorities to repay 300 million yuan ($42.3 million) in revised consumption taxes due to a "recategorization" of the aromatics-derivatives extraction equipment it had produced since July 2023.

Some of China's top provinces in tax and non-tax revenue generation, including Jiangsu, Shandong, Shanghai, and Zhejiang, experienced non-tax revenue growth exceeding 15% year-on-year growth in the first half of 2024, according to S&P's Huang. This reflects the government's efforts to diversify its revenue streams, particularly as its other major sources of income face increasing challenges.

The fall of the CKGSB Business Conditions Index to 48.6 in August has caused an uproar online and further damaged already fragile business confidence.

Since the Covid-19 pandemic, retail sales have slowly increased but not significantly.

Camille Boullenois, an associate director at Rhodium Group, stated to CNBC that the pressure to recover taxes from past years demonstrates the government's desperation to discover new sources of income.

The Chinese government in June admitted that some local governments had issued notices, but stated that these actions were standard procedures "in accordance with legal and regulatory requirements."

According to CNBC's translation of Chinese text on the administration's website, the administration denied allegations of "nationwide, industrywide, targeted tax inspections," and stated that there is no plan to "retrospectively investigate" unpaid taxes.

Earlier this year, Laura Li, sector lead for S&P Global Ratings' China infrastructure team, stated that revenue is the crucial problem that needs to be addressed.

""Government spending on education and civil servant salaries is often considered necessary, but it cannot be reduced as easily as spending on land development," she stated."

Debate on how to spur growth

To increase revenue, a direct approach is to focus on growth. However, due to the Chinese government's emphasis on reducing debt, it has been challenging to shift the policy from a long-term investment focus to a growth strategy driven by consumption, as per analyst reports.

According to Morgan Stanley's chief Asia economists Chetan Ahya and Robin Xing, in a September report, investment is contributing to weak nominal GDP growth outcomes, which is putting pressure on the corporate sector to reduce its wage bill and resulting in a sharp increase in debt ratios.

The longer the pivot is delayed, the louder calls will become for easing to prevent a situation where control over inflation and property price expectations is lost.

Deleveraging efforts from 2012 to 2016 resulted in a drag on growth, which led to higher debt-to-GDP ratios.

The same pattern is repeating in the debt-to-GDP ratio, which has increased by nearly 30 percentage points from 2021 to 310% of GDP in the second quarter of 2024 and is expected to rise to 312% by the end of this year, as stated by Morgan Stanley.

The official target of around 5% growth for GDP in the third quarter is being "moved away" from, as it is now expected to rise by 4.5% from a year ago.

The 'grey rhino' for banks

Major policy changes are tough, especially in China's rigid state-dominated system.

The investment-driven approach is linked to a network of local government-related enterprises that have assumed substantial debt to finance public infrastructure projects, which frequently yield minimal financial returns.

According to Alicia Garcia-Herrero, chief economist for Asia-Pacific at Natixis, the local government financing sector is often viewed as a "bigger grey rhino than real estate" by banks. Garcia-Herrero uses "grey rhino" as a metaphor for high-likelihood and high-impact risks that are being overlooked.

Chinese banks are more exposed to loans made to local government financial vehicles than to real estate developers and mortgages, according to Natixis' research.

Li, of S&P, stated that there is no known solution to the LGFV problems that can be implemented quickly.

"The government is attempting to buy time to address the most pressing liquidity challenges while maintaining the stability of the financial system. However, the central and local governments lack the necessary resources to solve the problem immediately."