China's Astonishingly Bizarre Land Development Finance System

One thing casual observers of China's real estate markets always try to say is that there is comparatively little leverage in the system, which means that any decline in prices is borne principally by the holders of the property and there are not ripple effects through the rest of the system. This is similar to how declines in stock prices tend to have very little collateral damage since they are very nearly entirely bought without leverage. Sure there is up to 2% of stock bought on margin in periods of excess, but compared to real estate markets, it's modest. That's why the stock market could shed $7 trillion in value during the 2000-2002 bear market and the broader economy felt very few ill effects from it. However, a similar decline in the value of residential real estate nearly destroyed the global financial system.

In China, however, it is simply not true that all real estate transactions are financed with equity. Indeed, a great deal of development is done by local governments, who engage in a program not entirely dissimilar from Tax Incremental Financing (TIF) in this country, where they borrow to develop certain properties and hope that they eventually pay for themselves (that's a very quick and dirty version of it). However, their practices are far sloppier than TIF districts in this country, and that's disheartening since a good number of TIF districts have run into trouble as well. Needless to say, in both cases, if the development stops, these financing deals run into serious serious trouble.

However, unlike TIF, properties are not valued according to fair market value, but in many cases in appears that local governments can just simply say what they're worth and use those amounts as collateral. This would be similar to if a financially troubled TIF district could hire an assessor to say that a $5 million hotel was really worth $57 million and collect the corresponding taxes on it. Fortunately, we have many safeguards in our system of property assessment and property taxation that prevent that from happening, including appeals and state oversight of local governments. China does not have much of a system of property taxation (though that is starting to change), and hence no good comprehensive system of property assessment.

Here are a couple of stories to chew on:

http://www.reuters.com/article/2011/07/14/markets-ratings-china-idUSL3E7IE0F520110714

http://www.bloomberg.com/news/2011-06-27/china-audit-office-warns-of-risk-on-1-7-trillion-of-local-government-debt.htmlAny source