China’s ‘three red lines’ strike delicate balance between curbing real estate debt and local government finances

As China moves to tackle excessive borrowing in the real estate sector, it is walking a tightrope between providing cash-strapped local governments with revenues from land sales and keeping a lid on rising house prices.

Chinese regulators in August tightened funding conditions for 12 major property developers, setting caps on the amount of debt they could hold in relation to cash on hand, the value of their assets and as a proportion of equity in their businesses – dubbed “the three red lines”.

Last week, mainland financial newspaper the 21st Century Business Herald reported authorities had asked large banks to keep the proportion of property loans below 30 per cent of all new loans, citing unidentified sources.

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Property sales growth has surged this year, helping the economy recover from the coronavirus pandemic. But it has also raised the alarm among top Communist Party officials who fret speculation in the real estate sector could increase house prices further.

In July, the Politburo – the party’s top decision-making body – stressed President Xi Jinping’s mantra that houses are “for living in, not for speculation”.

Given attempts to reign in property funding, analysts expect local government land sales to developers to weaken in coming months, something that could hurt regional finances and weigh on the broader economy.

“We don’t think Beijing wants to kill the property sector. After all, the economy is still running below its trend growth,” Macquarie Group said in a report last month.

“But it does send out a strong signal that Beijing wants to cool down the sector to save the ammo for the future. As such, property investment could peak soon.”

Zhang Ming, a researcher with the Institute of World Economics and Politics at the Chinese Academy of Social Sciences (CASS), said in August the central government does not want to see a sharp drop in property prices because it could cause risks for commercial banks, private wealth and local governments.

Land sales have been an integral part of China’s government finances at all levels over the past decade, according to research by Kate Jaquet, a portfolio manager at US-based Seafarer Capital Partners.

In China, land is owned by the state and the sale of land and user rights have been rising steadily since 2010, making up 38.6 per cent of China’s central government revenue last year, compared to 35.5 per cent in 2018, and 30.2 per cent in 2017, Seafarer Capital Partners said.

“One plausible explanation as to why Chinese authorities have allowed the listed portion of the sector to lever up so substantially, contrary to their stated commitment to reduce leverage in the financial system, is that this arrangement has been beneficial to the financial standing of the central and local governments,” Jaquet said in the June report.

Despite Beijing’s push for local governments to increase the use of municipal bonds for financing, regional economies still rely on land sales for a significant portion of revenue, said Nicholas Borst, vice-president and director of China research at Seafarer Capital Partners.

“This creates a dilemma where the central government wants to reduce risks in the property market, but fears that acting too aggressively might damage local government finances,” Borst told the South China Morning Post.

In fact, the central government has granted provincial governments greater autonomy over land conversions this year in a bid to promote land sales.

Local government proceeds from land sales grew 5.2 per cent in the first half of 2020, compared to a 1 per cent contraction over the same period last year, driven the State Council’s more flexible land policy introduced in March at the height of the pandemic in China, according to a report by Moody’s published in September.

Local governments typically acquire land from farmers at knock-down prices and re-sell the land for property and industrial development, but the property market often generates higher revenue than industry.

During a slowdown of the property market between 2014-15, local governments saw a decline in land sales revenue of almost 25 per cent, reflecting strong correlation between property market performance and money from sales.

Land sales have been an integral part of China’s government finances. Photo: Reuters alt=Land sales have been an integral part of China’s government finances. Photo: Reuters

Local governments are facing increasing financial strain across the board this year, thanks to lower tax revenues caused by weaker economic conditions and orders from Beijing to cut business taxes to help the recovery.

While the economy has rebounded in recent months, tax and non-tax revenue among local governments declined by 7.9 per cent in the first six months of this year, well below the official target of minus 3.5 per cent for 2020 and 3.3 per cent growth in the same period last year, Moody’s said.

Ni Pengfei, director of the Centre for City and Competitiveness at CASS, believes the latest property funding curbs are aimed at reducing debt in cities and sectors that rely heavily on the property market.

“[The three red lines] target certain cities, certain developers, certain financial institutions and relevant organisations,” Ni said in a blog post last month. “The targets are getting more precise.

“The impact on the real estate sector is yet to be seen but if they are executing steadily and appropriately, it could be meaningful, helping to direct funds into the economy for development purposes.”

This article originally appeared in the South China Morning Post (SCMP), the most authoritative voice reporting on China and Asia for more than a century. For more SCMP stories, please explore the SCMP app or visit the SCMP’s Facebook and Twitter pages. Copyright © 2020 South China Morning Post Publishers Ltd. All rights reserved.

Copyright (c) 2020. South China Morning Post Publishers Ltd. All rights reserved.

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