China's latest "Two Sessions" shine a light on the government's policy thinking at an important time. The government announced its economic growth target of around 5% and a budget that maintains fiscal policy little changed from last year during these meetings. This information is crucial to guiding investors as they navigate changes in China's economic conditions.

The many speeches and media conferences around the meetings also allowed the government to update investors of its views regarding the troubled real estate sector and off-balance sheet local government debts. In short, there is no plan to introduce measures to quickly clear up uncertainties in these areas. In the following, we answer key questions regarding announcements at the recent meetings in Beijing and what they may mean for government credit risks in China.

Frequently Asked Questions

What's the key message behind the economic policy announcements out of the NPC?

The premier's work report suggests industrial upgrading remains the thrust of economic policy. Risk control and steady economic support are also priorities. The government sees risks in three areas that need mitigating: real estate, local government debt, and smaller financial institutions.

The report prioritizes the upgrading of existing industries and promotion of new ones. Increased investment in, and reform of, the education system support this. In line with the "dual circulation" policy, the government also seeks to strengthen its external economic relations and bolster domestic demand.

The government signals it will maintain support for economic growth, with tepid increases in such measures. It has set a real GDP growth target for the year of around 5%. The general government budget deficit target is set at 3% of GDP and a special central government bond of Chinese renminbi (RMB) 1 trillion will be issued. These targets are in line with the numbers for 2023. Local government special bond issuance has also been set at a level only RMB100 billion above that last year. The government also aims to maintain credit growth close to that of nominal GDP.

Do local governments have fiscal space to support their local economies, if needed?

Some more than others. Policy support for economic growth of the local government sector this year is unlikely to be so strong that it risks fiscal sustainability. Nor is it likely to fade sharply without clear signs of a more solid recovery and confidence of project delivery. Indicative of this are the largely unchanged local sector general deficit and special-purpose bond new borrowing quota in 2024. We anticipate new local government borrowings to ease over the next two to five years.

Strategies among local governments will diverge. Debt management will take precedence over economic stimulation for those with high debt and limited revenue generation. We expect these governments to curb spending and make cuts to projects in order to stabilize deficits and curtail debt.

Conversely, local governments with lower debt constraints and greater resources may play bigger roles in pursuing policy targets in the near future. As the NPC emphasized, bigger regional economies will assume greater responsibility for economic expansion.

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What did tax collections in 2023 say about the state of the economy?

The 8.7% growth in total taxes in 2023 reflects a rebound in economic activity and a low base in 2022. Consumer and producer prices during the year were weaker than in most other major economies, which weighed down growth rates of major taxes. Income taxes indicate continued pressure on business performances and a sluggish labor market.

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The central government still reported a 43% gain in value-added tax (VAT) collections--its most important source of tax revenue--to register receipts of nearly RMB3.5 trillion. This sharp increase largely reflected depressed collections in 2022, when the government granted large VAT reductions. Even considering this, the VAT collection in 2023 was still nearly 4% above budgetary estimates, possibly reflecting the strength of the services sector, which recovered with the end of COVID-19 restrictions in the year.

Other tax categories did not perform well. The central government's share of the consumption tax--imposed mainly on luxury and high-value items--underperformed budget expectations and declined by 3.5%. This possibly reflected the change in Chinese consumer spending patterns, which included weaker sales of luxury goods.

Weak prices, the disruptions from the sudden easing of pandemic restrictions, and the continued weakness of the real estate sector dragged corporate income tax down 5.2% in 2023. Meanwhile, personal income taxes also dipped by about 1%, partly because of tax relief announced in the middle of last year. However, the decline likely also reflected the soft labor market conditions. Both types of income taxes underperformed budgetary expectations by more than nine percentage points.

Is China doing more to revive the real estate sector?

Yes, but with caution. The central government continues to view the problems in the real estate sector with perspectives of containing the risks and restructuring the sector to one that meets social demands better.

The government seeks to reduce risks to social and financial stability over the next year or two. Hence, its focus on policy support to help selected housing projects get financing so that they can complete construction. For this purpose, it has compiled a so-called whitelist comprising more than 6,000 projects eligible for bank lending. Banks have approved more than RMB200 billion of loans to some of these projects by the end of February 2024.

At the same time, the government insists that help with financing is not meant to support financially weak developers. Insolvent real estate developers should undergo bankruptcy or financial restructuring, the housing minister said.

Unlike the U.S., where the President recently announced new tax credits to promote home purchases nationwide, China continues to leave city governments to use policy decisions to stabilize homebuying in their jurisdictions. It does not believe that it should employ a broad policy tool to address the decline in home transactions and prices in many cities.

How can fiscally strained local governments ensure public services are not impaired?

With help. We anticipate the central government will continue to provide fiscal transfers to local governments to avoid service disruptions and to resolve arrears to contractors. We see these transfers as primarily intended to meet obligations such as social welfare and public services rather than to plug gaps in investment activities.

Past transfers have tended to prioritize the less developed regions, where fiscal pressures are greater. Total central government transfers grew 6.3% in 2023 and we project that they will grow another 4.2% this year. This projection reflects our view that a part of the proceeds from the recently proposed ultra-long-dated government bonds will be transferred to local governments.

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How does the Chinese government intend to address the risks of heavy local government debt?

The central government has signaled that it has no quick fix for the problem of local government off-balance sheet debt (that it calls "hidden debt").

For now, it is putting the responsibility of resolving these debts on the shoulders of local officials. Resolving off-balance sheet debts may take some time where the debt burden is heavy. Meanwhile, the central government is actively suppressing new off-balance sheet debt. In some cases, this has meant curbing local investment activities.

To reduce liquidity strains of local key state-owned enterprises (SOEs), the central government has allowed them to lengthen the maturities of certain debts, swap high-cost borrowings into cheaper bank loans or issue government bonds to refinance them. However, the responsibility of off-balance sheet debt repayment remains that of the local governments.

The central government expects local governments to moderate debt growth through gradual fiscal consolidation and avoiding off-balance sheet financing. It is likely to step in to help local governments directly with their debts only if it sees the risk of their financial problems leading to systemic instability.

We believe that the central government has sufficient financial buffers to absorb these off-balance sheet debts if it decides to recognize them formally as government debt. However, if the central government places these debts on its own balance sheet, it would be helping local governments that borrowed excessively at the expense of those that followed the rules. This could create governance problems and fan moral hazard.

How have local governments coped with the stress of falling land sales and growing debt pressures?

Chinese local governments have been cutting spending, especially land-related expenditure, to make ends meet. And the central government is urging them to make cost-cutting a habit. Some local governments have raised funds by selling stakes in state-owned enterprises. Several extremely cash-strapped governments had also turned to imposing additional charges or fines on, and delaying payments to, private businesses. To such behavior, the central government appears to be warning, "Quit it!".

Despite this sustained property downturn since 2022, real estate activities still generate much local government revenue. We estimate that land sales, along with property and land-related taxes, represented approximately 26% of adjusted local and regional government (LRG) total revenues in 2023 (inclusive of operating and capital account revenues, and central government transfers). This figure marks a decline from 36% in 2020.

Following years of encouragement from the central government, local governments have stepped up their divestment of SOEs. Due to such sales in 2023, receipts on the local government state-owned capital account rose by a third to RMB448 billion. Local governments channeled about RMB260 billion of these funds into the general budget.

Are more LRG debt swaps for off-balance sheet debts likely?

It's possible, but we expect them to be limited in size and scope.

Local governments as a whole have limited fiscal space to undertake additional debt swaps. In the final months of 2023, local governments issued about RMB1.4 trillion in special bonds to refinance off-balance sheet debts. This is equivalent to 4% of total local government outstanding direct debt. We estimate that future such issuances will be capped at RMB1.4 trillion for the coming years, because local governments are already nearing the mandatory debt ceilings assigned by the central government.

We do not view these swaps as a key feature of a broader solution for mitigating long-term risks within the local SOEsector. Lowering LRG dependence on local SOE financing infrastructure projects and transforming them into commercial SOEs (with improvements in cash flows) are among the long-term solutions.

How "tight" are local government budgets likely to be over the next two years?

Economic and revenue challenges are likely to impede a substantial fiscal recovery for most local governments in 2024. We anticipate largely stable deficits in the operating and capital accounts at just above 15% of adjusted total revenues through 2025, before more meaningful improvement in 2026. Material improvement in fiscal positions depends on a sustained economic recovery, in our view.

Multiple factors are likely to constrain revenue growth in 2024:

A slow land and property market.  We project a muted recovery in the property sector, which will limit the local government revenue from property-related sources. While the Chinese government's budget for a flat growth in land sales revenue, we are still seeing a drop of 5% for 2024.

Continued fiscal relief programs.  Tax and fee reductions and refunds will persist and curb revenue generation, in our view. China has been growing these programs in meaningful amounts since 2018 to counter slowing economy.

These revenue hurdles will necessitate careful spending decisions by local governments. Governments will likely be cautious about withdrawing their fiscal support from the economy too rapidly. The use of special-purpose bonds for project financing will continue to be a major driver of increased local and regional debt burdens over the next two years.

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Editor: Lex Hall

Related Research

• SLIDES: China City Governments Risk Falling Into A Debt Trap, Feb. 20, 2024
• China Deflation Risks Hinge On Growth Mix, Jan. 29, 2024
• China's Fiscal Bid To Stanch Local SOE Debt Risk, Nov. 2, 2023
• China Property Watch: A Slow, Sequential Recovery in 2024, Oct. 15, 2023