2015-01-21

Disaster In The Making: Small Cities Buy Their Own Land

Here's a story I missed last week: China’s small cities buy up their own land
Local governments in some of China's smallest cities are snapping up an increasing amount of their own land at auctions, in a destructive cycle designed to prop up property prices but which is ravaging their own finances.
Local government financing vehicles in at least one wealthy province, Jiangsu, which borders Shanghai, accounted for more land purchases than property developers did in 2013 — the last year for which data were available — according to research collated by Deutsche Bank.

The data signal that already cash-strapped local governments are switching money from one pocket to another rather than booking real sales.

The story is actually much worse, and localities may have used illegal methods to prop up land prices. Back in August I posted Systematic Fraud and Corruption in Land Sales Threatens Economy:
During the housing bubble, Chinese media often reported on a local "land king," a developer who paid an extraordinarily high price at a government land auction. Now we know why they were willing to pay sometimes seemingly absurd prices: the government was kicking back up to 80% of the total amount paid. Governments had already chosen the developer and fixed the price for the land, including signed contracts, with the auction a mere show for the public. If the auction price went above the contract price, the government would return the developer's money, plus interest.

Besides fixing a land sale before the auction, governments also reimbursed developers for development costs such as roads, sewers, and improvements. Land prices rose very quickly because once developer costs were included in the land sale price, developers starting running up costs, for example turning a ¥100 million project into ¥500 million. Then if the land auction went for ¥1 billion, the developer would only have to pay ¥500 million for the land, with the other half reimbursed. This helps explain why land sales totaled ¥130 billion in 2001, but last year, land sales totaled more than ¥4 trillion, an increase of 30 times. The total sales over this decade plus comes to nearly ¥20 trillion.

Governments also forced their state-owned enterprises to join in land auctions once the market cooled, in a process that was in essence moving money from one pocket into the other. As was previously reported, this also worked in reverse as governments sometimes used proceeds from land sales to prop up their SOEs. Other times they told developers to stay away and transferred land to SOEs at cost.

How much of these efforts fall afoul of the law, potentially falling into the category of corruption? The story from Fear Rises On Concern Land Audit Fallout May Have Only Just Begun in Shenzhen, could play out in many cities across China.

Even if there's no corruption, cities spending their own cash to prop up land prices is a case of pro-cyclical investment, or what Michael Pettis' dubs an inverted balance sheet.

This whole post is worth reading, but here's the part about land purchases from Inverted balance sheets and doubling the financial bet:
Clearly it is extremely risky for local governments, who are highly dependent on land prices for their revenues, to increase their exposure to land prices by buying up land at auctions. This is an obvious case of balance sheet inversion at the local government level. Some economist might argue that while it may increase risk at the local level, it does not do so at the national level. It simply represents a transfer of wealth from one group of economic agents to another. If real estate prices fall, for example, local governments will be even worse off than ever, but property developers will be better off because they are less exposed than they otherwise would have been.

There are at least two reasons why this may be totally mistaken. The first reason is that by propping up real estate prices local government may be helping powerful local interests who only want to sell their real estate in order to fund disinvestment or flight capital. The second, and far more important, reason has to do with the fact that financial distress costs are concave, not linear. If there is a transfer of wealth from one indebted entity to another, the latter benefits at the former’s expense. But the reduction of financial distress costs for the latter must necessarily be less than the increase for the former. Taken together, there must be a net increase in financial distress costs for China and a net increase in volatility within China. This is not the place to explain exactly why this must happen (I will do so in my upcoming book), but if it were not true, then it would not be the case that a country could suffer from excessive domestic debt.

1 comment:

  1. I agree with all of you that, this is really a good article which has some good and valuable information for us. Keep it up!

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