The Evergrande saga has captured global attention as one of the world’s most heavily indebted companies threatens to default on billions of dollars’ worth of debt. It’s not just foreign investors who are on tenterhooks, however. Land sales to real estate companies like Evergrande have been a vital source of revenue for cash-strapped local governments across China in recent years, which have used the funds to drive growth and economic innovation. 

As the real estate sector’s woes deepen, this cash flow is drying up, driving a greater story of revenue decline across hundreds of cities in China, as illustrated by recent research from the Rhodium Group. The decline’s uneven pattern will exacerbate regional inequality by degrading public services in financially distressed regions, and could also transform China’s political economy at the local level. As more localities lose fiscal autonomy, their ability to experiment with new policies will diminish, reducing the chance that local experiments can galvanize national level reform. 

Indeed if land sales continue to fall, it will hit second and third tier cities both along the coast and inland that have relied heavily on such revenue to make up for income shortfalls in recent years. Dozens of cities, including Chengdu, Jingdezhen, and Huai’an, may see a sudden cash flow contraction that impacts on public services and civil servant pay. Slowing sales will also likely reduce the value of land that local governments use as collateral to obtain credit for infrastructure investment: China’s financial regulators have already told banks to pay closer attention to the cash flows of borrowers, even if they are tied to local authorities. 

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Read our explainer on local government finances and their relationship with land sales here.

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The experience of China’s struggling northeastern cities over the last few years has shown how a combination of slower land sales and lower infrastructure spending can lead to prolonged periods of negative growth. To be sure, the Ministry of Finance still issues annual local debt quotas to such localities with high debt and weak economic prospects, in theory sustaining their operations. Even so, many local authorities in the northeast are highly indebted and dependent on central transfers, with interest payments rising as a share of their fiscal resources. Rhodium makes a convincing case that the slowdown in real estate, if unchecked, will see dozens more cities in China join the ranks of fiscal zombies prevalent in the northeast.

For ordinary Chinese living in highly indebted regions, the quality of public goods, from education to healthcare to public safety, will become inferior to those enjoyed by their peers in economically vibrant cities like Guangzhou or Hangzhou. For example, expenditure on public services and rural community affairs in Jilin, a northeastern province, barely budged between 2016 and 2019. Meanwhile, in prosperous Guangdong Province, such expenditures rose by over 60% over the same period. 

The rising fiscal dependence of cities and provinces on central government resources will further erode their discretion to carry out policy experiments, other than those explicitly endorsed and funded by the center. 

The desire to migrate to better-off cities is set to intensify, driving land demand and prices even higher there. The central government can counter this tendency by increasing transfers to poorer regions, but such payments did not increase much even during the pandemic, thanks to Beijing’s innate fiscal conservatism. Nor has the central government relaxed hukou policies much in the top tier cities, meaning new migrants remain unable to enjoy adequate public services even in more prosperous places. The real estate slow down inland — and in some less well off coastal cities — will intensify this trend, causing greater regional inequality. 

There will be implications for the broader regime, too. One of the Communist Party’s key strengths has been the degree of policy and fiscal autonomy given to city and county level leaders throughout much of the reform period. This has allowed hundreds of policy experiments to proceed locally which, according to research done by Harvard’s Elizabeth Perry and University of Trier’s Sebastian Heilmann, have ultimately improved the quality of policy making in China and helped it to avoid some important pitfalls, such as autarky. The proliferation of local experiments has also allowed reformers in Beijing to convince conservative colleagues of the merits of various reform measures after they have been successfully implemented at the local level. Household farming and the privatization of housing both began as regional reform experiments which were ultimately adopted nationally. 

The leadership in Beijing has already been sending strong signals in recent years, urging local leaders to adhere to “high level designs” from the center. The rising fiscal dependence of cities and provinces on central government resources will further erode their discretion to carry out policy experiments, other than those explicitly endorsed and funded by the center. To be sure, wealthy cities like Shenzhen and Hangzhou will continue to carry out policy experiments, even very elaborate ones. However, their needs and problems will be very different from those faced by the majority of second and third tier cities. 

Slowing land sales and eroding fiscal autonomy will mean that vast numbers of cities will increasingly lack the means to explore their own policy models, leading local leaders to redouble their efforts to lobby for funding from the center instead of thinking about local policy reforms. In turn, if policies “designed on high” don’t hit the mark, there will be a heightened chance of prolonged reform stagnation across many policy areas. 

Evergrande’s debt crisis may have already caused some short-term pain for the international bond market. The problems faced by it and other property developers will have consequences for China’s economy that will likely last for years to come. 

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