China faces biggest fiscal challenge since 1981

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Chinese fiscal revenue growth is set to hit its lowest level in more than three decades this year, Deutsche Bank warned, which is likely to add more downward pressure on a slowing economy.

"We forecast the growth of total government revenue will slow to 1 percent in 2015 from 4 percent in 2014 and 19 percent on average from 2009 to 2013," the bank said in a recent report, stating that 2015's pace of growth will be the slowest since 1981. It also predicts growth of local government revenue will drop to -2 percent this year from 2 percent in 2014.

"We believe this is the most important risk to the economy and one that is not well recognized in the market," the bank added.

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The slump in land sales, which make up 23 percent of national government revenue, is to blame for the fiscal crisis, according to the report. Land auctions plunged 55 percent in the third-quarter and averaged a decline of 40 percent across 300 cities all of last year, according to Deutsche Bank

"The reality is that the land market started to cool down sharply in March 2014, but from a fiscal revenue perspective in annual terms, land sales remained positive until Q3 2014. We believe the fiscal shock to local government revenue only started in Q4," Deutsche Bank said.

Buyers usually make payments to local governments within two quarters of the completed auction, so the fiscal impact of lower land sales will only be felt in the first half of 2015, the report said.

China's property slowdown is seen as the primary reason behind dwindling land auctions.

Land sales value in 300 cities dived 27 percent on year in the 2015 financial year, according to a report from Citigroup this month. "We believe slowing land sales reflect sluggish physical market and reluctance of local governments to launch land sales during a low period," analysts Oscar Choi and Marco Sze said.

The trouble with LGFVs

The dominance of local government financing vehicles (LGFVs) in land markets is exacerbating China's fiscal slide, experts warned.

LGFVs are "notorious funding platforms that helped pay for China's post-2008 housing and infrastructure construction boom and whose borrowing accounts for the majority of China's nearly 18 trillion yuan ($2.9 trillion) in outstanding local government debt," according to a note from global intelligence firm Stratfor last week.

Local governments have increasingly used these funding vehicles, also described as shell companies, to buy up land in their own towns to support property prices as real-estate developers reduce investments in new projects. In the Jiangsu province, Deutsche Bank noted that LGFVs accounted for 70 percent of all land sales in 2013 and 2014.

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As local governments account for nearly 90 percent of China's total government expenditures, Stratfor noted, so the debt burdens of LGFVs have a direct impact on China's fiscal situation.

"The rise of LGFV land purchases underscores the urgency of fiscal reforms in China. As long as local governments remain heavily dependent on land sales as sources of revenue, and as long as local governments are responsible for the vast majority of government expenditures in China, they will continue to seek - and find - means of making those sales and generating that revenue, however unsustainable," Stratfor said.

The firm recommends China's leaders create new avenues for local governments to raise their own funds through municipal bond programs and new taxes, instead of LGFVs.