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China’s Tax Revenues: An Embarrassment of Riches

July 25th, 2011 No comments

You’ve got to love the timing. With U.S. mired in a debt and spending crisis, with tax revenues stagnant and its government about to run out of borrowed money to spend, the Chinese government just announced that its fiscal revenues during the first half of 2011 rose by 29.6% compared to a year earlier. One country is a fiscal train-wreck, the other a fiscal gusher.

China’s tax revenues are surging for a host of reasons that set it apart from the US – the economy is booming, and in particular, businesses are thriving. According to the Chinese Ministry of Finance, profit taxes are growing especially quickly. Income and corporate tax rates are stable, at rates far lower than the US. China levies a nationwide VAT, while most of the US charges sales tax. Consumer spending is growing by over 20% in China, while it’s basically flat in the US.

To all these must be added another crucial difference: China is modernizing so quickly, that every year money pours in from new sources. China doesn’t need to raise tax rates to increase tax revenue. It just allows its citizens to get on with their lives.

Take auto sales. A decade ago, China produced and sold about two million cars. This year, it will sell about 20 million. China passed the US two years ago to become the world’s largest auto market. Since then, sales have grown by a further 40%.

Along with creating some of the world’s worst traffic congestion, all these new car sales do wonders for the country’s fiscal situation.  Start with the fact that every car sold in China has not just a 17% VAT built into its price, but a host of other taxes and levies. A consumption tax adds as much as 40% more to the sticker price depending on the size of the engine. Customs duties are also levied on imports.

These all add up fast. The government’s tax take from the sale of a single Mercedes-Benz can easily top Rmb325,000 (US$50,000). Last year alone, sales of Mercedes-Benz in China doubled. This year, Mercedes will sell about 180,000 cars in China. Total tax take: about USD$1 billion. Keep in mind that Mercedes-Benz has less than 1% of the Chinese market. BWM, Porsche and Lexus are also doing great in China. While they are all doing well, the Chinese government does even better. The government earns far more on the sale of every luxury car than the manufacturers do.

The sales and consumption taxes are just the start. Most news cars in China are sold to new drivers. That means, every year, there’s a significant net increase in the consumption of gasoline. Each liter of gasoline also carries a variety of different taxes – VAT, consumption tax, resource tax. Plus, almost every gas station and refiner in China is owned by companies majority-owned by the Chinese government. So, profits at the pump flow back to the government.

At the moment, the gasoline price in China is about Rmb7.5 per liter,  or Rmb30 ($4.60) per gallon. Figure the Chinese government is making about Rmb10 ($1.50) per gallon sold in tax. Each new car sold this year will likely contribute an additional $500-$600 in fuel taxes, or about Rmb100 billion in total. Again, a big chunk of that will be a net increase in fiscal revenues, since there are so many new drivers each year.

Think the same for sales of new apartments, air-conditioners, iPads and iPhones, plane and high-speed train tickets. Each one has all sorts of taxes built into its sales price, and then an annuity of future tax revenues from energy taxes, fees and assessments.

In the US, taxes and spending are so high, people grow more and more reluctant to spend. Huge budget deficits today, as Milton Friedman long ago established,  creates the expectation of tax increases tomorrow. Americans adjust their spending accordingly. Not so in China. Chinese keep spending and the government reaps the bounty.

As flush as the Chinese fisc now is, tax revenues represent only one part of the government’s huge cash hoard. To begin with, there is the over $3 trillion in official foreign exchange reserves. This money contributes little to no benefit to the economy as a whole, except bottling up pressure on the Renminbi to appreciate against the dollar. It’s basically money buried in the backyard.

The government also owns significant – often controlling — shares the country’s biggest and most profitable companies, including SinoPec, China Mobile, China Telecom.

Net profits at the 120 biggest centrally-controlled Chinese SOEs rose by 14.6% year-on-year during the first half of 2011, reaching Rmb457.17 billion yuan ($71 billion) . These 120 SOEs are meant to pay taxes and levies of almost twice that, Rmb850 billion, up 26.4% from 2010. No one quite knows how much of that money actually reaches the Chinese Treasury. But, of course,  the money is there, should it be needed – in a way the US Social Security “Trust Fund” most assuredly is not.

Real Estate Prices in China – For Many, Higher Means Happier

July 18th, 2011 No comments

China’s government is engaged in mortal combat to control rapidly-rising real estate prices. Or so you would believe from reading the newspapers and listening to all the economic commentary. But, it’s not entirely true. The reality is, China’s government is trying to navigate a tricky path between the interests of current homeowners, and those who’ve yet to join the housing ladder. Current homeowners, of course, are perfectly happy for prices to keep rising. In today’s China, homeowners are one-and-the-same with the country’s most important political constituency.

When I first came to China in 1981, this country was, both in its rhetoric and policy, still a nation of and for “workers and peasants”. These “have-not” groups enjoyed preferential access to housing, jobs and higher education.

Today, most power belongs to society’s “haves”, the urban and educated population that creates and captures the benefits of China’s remarkable economic growth. The government must seek to keep this group content. The easiest way to do this, of course, is to create policies and conditions where personal incomes continue to rise. Since most personal savings is tied up in housing and the stock market, the government must focus heavily, in ways perhaps no other government in the world does,  on measures that produce favorable outcomes for people with money tied up in property or shares.

Overall, China’s government has been consistently successful doing this. With housing prices, they’ve perhaps been a little too successful, since the policy mix has created a situation where prices continue to rise by over 50% on an annualized basis, and are now often higher, per square meter, than they are in most of the US and Europe. For the tens of millions who have owned property for more than six months, this translates into very significant increases in personal wealth.

In short, for every person currently priced out of the housing market, there maybe three or four who are feeling flusher than they ever have. That means, if you could measure such things, greater net happiness in China when property prices are rising.

China’s government, if it wanted to,  has the power to drive down housing prices in a hurry. It owns all the land in China. By releasing more of it for residential development, the certain outcome would be to lower or even roll back the growth of housing prices. Yet doing so will also have wealth effects on those who already own.

The other policy levers at the government’s disposal – introducing property taxes, restricting people from buying more than one residential property, raising minimum down-payments,  – can have some impact. These are the main tools the government is now using to moderate housing price inflation. But, all evidence is, these steps aren’t having a major impact. Property prices continue to rise, if less explosively than they did in 2009 and 2010.

Most of the talk from government is about increasing affordable housing, especially in cities. But, the policy mix is still designed in such a way that prices should continue to move upward.

Hong Kong is a constructive example. There too, property prices are high and moving higher, and the government is tinkering with policy changes to slow rapid increases. But, high property prices have been a fixture of Hong Kong life for a generation.

The Hong Kong government owns most of the undeveloped land. It tightly controls the amount of new land auctioned each year. This maximizes the government’s profits from land sales, while sustaining upward pressure on property prices overall. This makes all current owners, from large developers like Li Ka-shing’s Hutchinson Whampoa and Cheung Kong Holdings, happy as well as the two-thirds of Hong Kong citizens who own their own homes.

Home ownership in China is not quite as high overall. But, it is likely just as high, if not higher, among the huge part of China’s population whose political and economic clout is greatest. China is wise to want to extend to more people the benefits of home ownership. But, the next time you hear that China’s property prices are rapidly rising, the meaning is: the country’s very many haves now have very much more.

China’s Most Profitable Industry Becomes One of the Toughest

July 7th, 2011 4 comments

Chinese real estate is no longer the easiest legal risk-adjusted money-making business in the world. It’s been a swift reversal. For the better part of twenty years, there’s been no simpler way to amass a great fortune than developing property in China.

The business model was as simple as it was profitable: acquire a piece of property from friends in government at a fraction of its market value, mortgage the property heavily with obliging state-owned banks, sell out most of the units (either offices or apartments) within weeks of construction beginning, and then pocket returns of 500% or more before the building was even occupied.

Continuously rising property prices, often increasing by 10% or more per month,  provided incentive to hold onto some units for later sale. A final wrinkle was to demand a cash advance from the construction company when awarding the building contract, so limiting even more the amount of capital needed, and improving return-on-equity even more.

There was just about zero risk in deals like this. Then, the Chinese government began clamping down, starting gingerly about a year ago and then with added ferocity in recent months,  in an effort to restrain property prices and overall inflation. At this point, what was once the easiest business in China has become one of the hardest. Sweetheart land deals are far more rare, as the central government in Beijing is no longer turning a blind eye.

More importantly, banks have all but stopped lending to property developers. This has dried up liquidity in an industry that was for many years awash in it. The projects getting built now, for the most part, are those where little or no bank debt is required. That means heavy upfront equity investment, or taking money from loan sharks who charge interest rates of 25%-30% a year. This fundamentally alters the arithmetic of a real estate deal in China. The more equity and high-interest debt that goes in, the lower the returns and, it seems,  the more likely a project is to hit problems.

And problems have become the norm. Another government change, little reported but absolutely crucial to the change in fortunes of the real estate business in China, is that it’s no longer easy and cheap to get current residents off the land, so it can be sold at a high price to a developer. New rules make it very expensive and risky for any developer to undertake this process of relocation and demolition.

Any delay, and delays are rampant, can quickly drain away a developer’s cash. For example, if one old tenant refuses to take the relocation money and move out, it is no longer a simple thing in most instances to get the local government, or hired goons, to force them out. Until all old tenants are resettled, no construction can begin. This can push back by months or even years the date that developers can begin pre-sales. Meantime, you keep paying usurious interest rates to lenders who have taken the whole project, as well as many of other unrelated assets, as collateral.

A final nail: residential real estate prices are now rising far more slowly. This is the result of tighter mortgage rules, property taxes in some cities, as well as new regulations that limit the number of apartments people can buy. In Beijing, for example, you need to prove you have paid local Beijing taxes before being allowed to buy.

Of course, taking the easy money out of real estate is a prime policy objective of the Chinese government. That the government would be successful in this was never much in doubt. The speed and geographical scope of the impact, however, has caught a lot of people (including me) by surprise. Projects that six months ago looked like sure things are today struggling. The sudden evaporation of bank finance, in particular, is playing havoc. Banks in China are state-controlled. When they responded slowly, earlier this year, to government suggestions they slow the flow of funds to the real estate sector, the government took more active measures, including raising six times banks’ reserve requirements.

Rocketing property prices are a major contributor, directly and indirectly, to inflation, which is now, by official figures, at its highest level in China in over three years. So, the government’s actions had a broader purpose than altering the return formula for real estate investment in China. At the moment, though, that’s been the main impact, to make it far harder to do both residential and commercial real estate projects in China. When and by how much inflation will be curbed is unclear.

The bigger question is: has the game changed permanently in Chinese real estate, or will things revert as soon as inflation is down to where the government wants it to be. The rising real estate prices of the last 20 years have not only helped the country’s real estate barons. They have also been a main source of rising middle class wealth in China. That’s where the government policy becomes more an art than science: how to strip away real estate developers’ easy profits, while keeping the middle class feeling flush and contented. I’ll write about that in a following blog post.