China: Real-estate Debt Crises-Ghost-Cities, No one pays taxes, $13T Speculative Bond Bubble.

China faces significant tax challenges, stemming from its dual identity as the world's second-largest economy with sophisticated financial systems and global trade networks, alongside its predominantly informal economy. The country's substantial economic scale necessitates extensive government expenditure, which in turn relies on a robust and expansive tax base for funding. Regrettably, China falls short in this regard. In contrast, the United States, a comparable economic counterpart to China, boasts federal tax revenues amounting to approximately 17% of GDP, or around 25% when factoring in all local and state revenues. In comparison, China's revenue stands at a mere 9%.

China faces a triple challenge in tax collection. Firstly, they struggle to collect taxes from the majority of the population. Secondly, those individuals from whom they can collect taxes often find ways to evade them. Lastly, even the taxes that are successfully collected are not always allocated appropriately. With a population of 1.4 billion, China's centralized system relies on provincial and regional governments for operational oversight. Unlike many developed economies where local governments rely on property taxes and funding from higher levels of government, China's local governments derive their main revenue from business taxation and long-term land leases by selling off 20 to 70 year leases on their land holdings in China, as private ownership of urban land is prohibited. While a significant portion of business tax revenue must be remitted to the central government, revenues from land leases remain with the local governments. This unique revenue model is particularly crucial due to the immense size of China's real estate market.

The country found itself in a real estate debt crisis. Land lease revenues are dependent on the land's development value, which, in turn, relies on the presence of supporting infrastructure for the future residents. Consequently, provincial governments engage in an ongoing competition to enhance infrastructure, aiming to become economic centers by selling land rights to finance further development. This cycle results in an excess of infrastructure, leading to the creation of ghost cities and underutilized railways, commonly observed in China during real estate debt crises. Moreover, provincial governments face the challenge of substantial initial investments, compounded by restrictions on bond issuance until land sales generate revenues. To address this, they establish local government financing platforms which is as dodgy as it sounds, where a private entity is formed to receive state assets such as cash, shares, state enterprises, or land rights. This entity can leverage these assets as collateral to secure loans from banks, enabling the government to fund infrastructure projects while banks can securitize these loans into bonds for sale on the market.

In 2019, Local Government Financing Bonds made up 39% of all bonds outstanding in China's domestic market, while the remaining 60% primarily consisted of real estate bonds issued by development companies seeking funding for construction on leased land from these local governments. These local government financing platform bonds are considered relatively secure due to their indirect support from the communist party, leading many Chinese investors to believe that government default on these debts is highly unlikely. Additionally, this strategy helps shift government debt to the private sector, making national debt to GDP ratios appear more favorable than they truly are.

Indeed, the issue lies in the fact that these are local governments, not the national government, and they face a high risk of bankruptcy due to limited revenue-raising options. Up to now, this situation has not been problematic because the real estate market has continuously appreciated, allowing even the most reckless borrowing practices to be covered by the profits from leasing out land. However, this fragile status quo is beginning to unravel. With China implementing strict lockdown measures to combat the spread of Covid, following a zero-case policy, even large cities like Shanghai are subject to complete lockdowns. Under these lockdowns, individuals are prohibited from leaving their homes except for essential grocery shopping, resulting in a significant decline in business activity and cutting off a major revenue source for local Chinese governments.

The real estate sector in China is experiencing challenges due to recent high-profile property development bankruptcies, leading to a decrease in public confidence in real estate investments. This decline in investor interest has resulted in fewer properties being built, leading to reduced revenue for local governments from land holdings rentals. Additionally, banks are now hesitant to accept these land holdings as collateral for underwriting bonds used by local government financing platforms. The Chinese central government is trying to address the situation by providing tax returns to citizens to prevent them from being trapped in their homes during economic lockdowns, while also promoting infrastructure projects to mitigate the economic impacts of the lockdowns. However, this approach is causing a decrease in revenue and limited options for bridging the financing gap. The reliance on highly speculative financial assets backed by a booming real estate market is raising concerns, especially since most bonds in China are rated as double A and local government financing bonds are exclusively rated at AAA, suggesting a false sense of security to investors. This situation poses a risk to the $19 trillion bond market, which relies on continuous growth and could potentially lead to a significant market collapse. Despite the perceived safety of these investments, there are underlying risks that could have severe consequences, potentially requiring intervention from the central government to bail out local governments and protect the party's reputation.

They may encounter difficulties in doing so. The Chinese bond market is enormous, with a total value exceeding the global mortgage-backed securities market of 11 trillion dollars, and in many aspects, it was likely better regulated. This market surpasses China's entire GDP significantly. Another major issue concerns how the Chinese government manages land. As 20-to-70-year leases approach expiration, the government faces the challenge of determining the next steps for the land. While the traditional agreement dictates that the land should revert to the government, this idea is met with strong opposition from residents who would be displaced and lose their significant investments. Many Chinese citizens now believe that the government will not reclaim the land once the leases expire due to its political unpopularity. The real estate market reinforces this belief, as properties with varying lease durations are priced equally; homes with 20 years left on their land lease cost the same as homes with 70 years left on them all other things been equal people are unlikey to invest in the former, suggesting a lack of concern for the lease term. The uncertainty is compounded by building standards in China, which may not ensure the longevity of properties. Furthermore, recent laws kept deliberately vague, state that residential land rentals will be automatically renewed, but they do not specify whether this renewal will be free or if landholders will be required to pay for a new lease.

One of the members of the drafting team responsible for this law later confessed that they purposely left it ambiguous because they didn't want to be accountable for deciding how to resolve the issue if the government eventually decides to indefinitely extend land rentals. If there were no additional fees, they would have deprived themselves of a major source of revenue. This brings us to another issue China faces with tax evasion - many individuals do not fulfill their tax obligations. While China does have progressive income tax rates ranging from 3% to 45% based on earnings, a large portion of the population evades paying taxes. Most Chinese citizens work in the informal sector, running small businesses, working on farms, or engaging in cash transactions through platforms like WeChat. Those at the higher end of the income scale often channel their earnings through businesses and assets to significantly reduce their tax liabilities. Only a small minority, who are neither extremely wealthy nor able to avoid taxes, end up paying their dues. Numerous scandals involving prominent Chinese business figures and celebrities exploiting tax loopholes have surfaced, indicating that the government could crack down on tax evasion if it wished to. However, two reasons prevent this from happening: firstly, lenient business tax regulations stimulate economic activity, which has been a key driver of China's remarkable economic growth in recent decades; secondly, the government can always investigate and prosecute tax evaders when necessary, serving as a tool to silence dissenters or influential figures. Nonetheless, this approach creates issues as taxing only a small percentage of the population not only burdens honest taxpayers unfairly but also hampers the government's ability to generate consistent tax revenue and limits its control over the economy.

Recently, there has been significant emphasis on monetary policy due to the unprecedented high inflation levels. However, fiscal policy, involving the adjustment of taxes and government spending, is equally, if not more, crucial for effectively managing the economy. Raising taxes can effectively control inflation, while reducing taxes can boost economic growth in challenging periods. Nevertheless, tax breaks are only impactful if the population was initially subject to taxation. Failure to impose taxes on the majority renders this control ineffective, as taxing only a small segment of the population limits the government's economic control over its economy.

With a GDP of $14.7 trillion, China's economy is distributed across the world's largest population, resulting in a GDP per capita of $10,400, positioning it as a middle-income nation on a global scale. Despite the substantial economic presence of China, concerns persist regarding stability and confidence due to the government's significant control and military ambitions, which pose sovereign risks. China's remarkable growth has transformed it into a major economic powerhouse, with its economy more than doubling since 2010 and growing over tenfold compared to the year 2000, outperforming any other economy. Regarding industry, China being the workshop of the world, its ascent to its current status as a global economic force stems from its evolution from a low-cost manufacturing hub for foreign companies to a sophisticated industrial center with an advanced financial system, a robust domestic market, and internationally acclaimed local enterprises. While China excels in industrial production, its not a match for high-end sectors like aircraft manufacturing and competitive microprocessors.