While all eyes are turned to China's tumultuous stock markets, the real threat to China's financial well-being lies with the country's cash-strapped local governments.
Between 1998 and 2012, China's towns and villages had a revenue shortfall of 18 trillion yuan ($2.82 trillion), according to a recent paper by the International Monetary Fund. Of that fiscal gap, 13 trillion yuan was filled through land sales and another 5 trillion yuan was generated from shadow banking, namely wealth management products sold by the country's 67 provincially owned trusts, and state and private banks.
With the air gradually hissing out of the property bubble, land sales are falling fast. These declined 55% in the first half of 2015, as developers shied away from deals.
Earlier this month, I visited Sichuan Province in central China. Chengdu, the capital, has around a 30-year inventory of land available for commercial development. An agent who assists the government in conducting land transactions said: "In 2013, we would beg the government to sell land. Now the governments come to us. They are desperate to sell land."
Follow the money
How did this situation arise? The revenue shortfall is the result of Deng Xiaoping's striking economic reforms in the 1980s. As private business started to flourish, more money began to flow outside of official government channels -- and tax revenues to Beijing fell.
In 1994, a panicked Premier Zhu Rongji rammed through a series of tax reforms in a political deal with sub-provincial governments. Beijing would take the lion's share of tax revenues but agreed to remit a portion back to the provinces. Central government revenue suddenly jumped from 22% of the national total in 1993 to 50% by 1998.
However, much of the burden of social spending remained in the hands of local governments. That burden has become heavier over time as Beijing forced through spending increases, as also has happened in Western countries, and state firms collapsed or were shut, dumping retirement costs on the government.
Beijing pays less than one-third of the cost of social services, including education, health and social security. More than half is covered by municipalities, townships and villages.
In response, local governments began instituting all sorts of administrative fees, from business registration taxes to car-parking charges. But it was not enough to fill dwindling state coffers.
However, like a magic wand, China's flourishing property market provided a new source of capital: land. Governments had the right to take peasant land for a nominal fee and resell it at a huge profit.
As the IMF paper noted, "Following the 1994 fiscal reform, local governments' share of land sales proceeds increased from 40% to 95%. Land sales thus became a major source of revenue for local governments as urbanization advanced, with the proceeds usually accruing to government-managed funds."
But that game is over. Local governments are resorting to desperate measures to keep revenue flowing. These include borrowing short term at high rates from private lenders. The authorities are also pressuring banks to mortgage "pre-sold" land, essentially securitizing plots that are expected to generate revenue in the future. They are also pushing local government-owned companies to lease land and hospitals to move to less central locations to free up sites for commercial development.
These are risky ways for a government to operate. Meanwhile, local governments have amassed a pool of debt officially counted at 17 trillion yuan but probably closer to 30 trillion yuan in reality.
In March, the People's Bank of China, the central bank, swooped in with a bold plan to transform messy local finances into a real market. It authorized local governments to sell bonds that would be swapped for local debt.
The goal is to create a transparent debt platform equivalent to the municipal bond market in the U.S. The initial tranche is 2 trillion yuan, but there is an expectation there will be more.
Although a great idea, implementation has been chaotic. Banks, which buy most bonds in China, spurned the first such bond offer in Jiangsu Province because the interest rate was too low. The central bank relented by raising the interest rate slightly above the national government's bond rates and agreed to allow banks to use the bonds as collateral for an injection of central bank cash.
Meanwhile, bankers said that some of the cash the governments had been getting for paying off bank loans was actually going to other private lenders in the shadow banking market.
In the end, the banks are probably going to be losers. Although the new bonds have a lower risk weighting than the old loans, overall returns are lower than before when all factors are put together. One banker said his institution was losing an average 0.7% on every transaction.
But while the bond swap is a nice, neat central-government start toward dealing with the stock of local debt, it does not resolve the underlying cash-flow problem of falling tax revenue. Beijing is going to have to be a lot more creative. Possible solutions include instituting local property taxes, which would hurt the market during the current downturn; selling inefficient companies owned by local governments; and forcing the local government financing vehicles that were the original borrowers of the debt to be responsible for their own profits and losses.
However, there appears to be little appetite at this stage for wholesale fiscal reform. In the end, the banks are likely to absorb the losses.
Andrew Collier is managing director and founder of Orient Capital Research in Hong Kong.