The second wave of shocks in China

As the housing crisis in China drags on from 2021, a second wave of shocks may deal another heavy blow to the property sector. Thanks partly to hefty revenues from land sales, China’s local governments had played the role of “helping hand” by promoting growth and attracting business. However, with land sales revenues evaporating, mounting debt and the lofty burden of maintaining public security, local governments have shifted to become “grabbing hands” by charging high fees, imposing fines and strengthening tax collection.

This may be the impetus for a second wave of economic shocks that could undermine the foundations of China’s success story, according to Nomura analysis. If the housing crisis represents the first shock from the demand side, the shift by local governments to become “grabbing hands” would represent the second shock from the supply side. Under this new shock, fiscal policies and reforms should take the front seat. Beijing could provide direct funding to stabilize the property market, as the housing crisis is the root cause of these shocks. Beijing could also ramp up transfers to alleviate the fiscal burden on local governments while working on longer-term solutions. While buying time and targeting a soft landing, China could streamline its fiscal system, link its transfers to local growth, limit the size of local governments and instill confidence by promoting the rule of law.

From “helping hands” to “grabbing hands”

One of the key drivers of China’s monumental growth over the past four decades has been fiscal federalism, which provided fiscal autonomy to local governments, promoted market development and facilitated regional competition. For most of the years since China opened up its economy in the late 1970s, local governments have generally been perceived as “helping hands”. This was further augmented by the performance-based promotion system, which incentivized local officials to prioritize growth.

Even as China revamped its whole fiscal system in 1994 by concentrating revenues at the central government level, fiscal federalism remained. The market-based housing reforms in the late 1990s provided a new and massive source of revenue for local governments. At its peak in 2021, total revenues from land sales, all of which went to local governments, reached RMB8.7 trillion, or 7.6% of GDP.

But as this revenue stream evaporated amid the housing crisis since 2021, local governments have been forced to scramble for cash to maintain basic operations and wage payments. There is increasing evidence — especially the surge of non-tax fiscal revenue — that suggests the golden era of fiscal decentralization and performance-based promotion is fading. As “helping hands” shift to “grabbing hands” across a rising number of localities, China’s economy may face new headwinds.

The growth slowdown is set to worsen in H2

In the second wave of shocks, the “grabbing hands” local governments hiked up fines, charges, and became stricter in taxation. As such, corporates may reduce investment, cease expansions, delay hiring and cut employment. Some may even intentionally choose not to do anything. Households may also become more cautious to avoid unnecessary fines. China’s GDP growth has already dropped from 5.3% year-over-year in the first three months of 2024 to 4.7% in the subsequent quarter. If Beijing does not address fiscal tensions soon, economic growth could slump further in the second half of 2024.

Policy implications

To achieve China’s “around 5%” growth target, Beijing needs to decisively stem any further decline in the housing sector, ramp up fiscal transfers to local governments and slow the shift to “grabbing hands”. Conventional monetary policies such as rate cuts are losing relevance as business confidence has weakened. Central government’s spending, in turn, has become much more important. China still has a long way to go on urbanization, so stabilizing the property sector is still a viable policy option for boosting short-term demand and promoting long-term fiscal federalism.

In the medium to longer term, Beijing will have to carry out major fiscal reforms to rebuild fiscal federalism as land sales are unlikely to remain the primary source of local government revenue. On the expenditure side, Beijing may need to streamline local governments and reduce unnecessary fiscal burdens. While providing local governments with a larger share of taxes, Beijing could simultaneously cap the size of fiscal transfers to re-introduce fiscal discipline amid some decentralization. These fiscal transfers could also be designed to encourage urbanization by linking it to the increase in residents and school children. Beijing could also introduce a better market-based mechanism for allocating urban land quotas so cities can grow as people migrate there. Lastly, constraining local governments’ “grabbing hands” requires improvements to upholding the rule of law.

For more on our growth projections, read our full report.