Emerging from the shadows

RESIDENTS OF CHAOBEI NEW CITY know what it is like to be “upstairsed”—the word for turfing farmers off their land, pushing them out of their homes and making them move into newly built clusters of blocks of flats without lifts. It is forced urbanisation, to which local governments have taken with relish in their rush to acquire precious land. Chaobei New City is the reincarnation of six flattened villages: a desolate, prison-like, rubbish-strewn ghetto. On a concrete wall along one side, billboards spell out the risks of protesting. For example, depositing funeral wreaths, ashes from cremations or corpses at government petitioning offices could be treated as crimes.

Chaobei New City’s very name conveys the mindset of those who ordered it built: officials who hoped that by destroying the villages and building 56 blocks of flats in their place they could create a semblance of urbanity. The residents would still be classified as peasants for welfare purposes, but the statistics would count them as urban. To local officials, who take enormous pride in urbanisation rates, such numbers matter. Xianghe county, to which the “new city” belongs, is in Hebei province, about 45km (30 miles) east of Beijing. Like almost every other local government in China, Xianghe’s has an urbanisation target: 60% by 2017, up from around 50% today and ahead of the national target of 60% by 2020. Since the global financial crisis in 2008, governments have been hardening such objectives as a way of stimulating growth, and have been borrowing heavily to meet them. The result has been a rapidly growing pile of debt that has spooked global investors.

Seizing land is an easy way of acquiring cash or collateral for borrowing, and since the 1990s this technique has become a favourite of local governments. Some have used the pretext of building what they call “new-style rural communities”, such as Chaobei New City. Such schemes have uprooted millions of farmers around the country. In one prefecture alone, Chinese media quoted a local leader in 2010 as saying he planned to flatten villages with a total population of 1m within three to five years. The coastal province of Shandong has moved more than 12.5m villagers into nearly 5,200 “new-style rural communities” since 2009, according to the local government. It calls this “urbanisation on the spot”.

Mod cons from hell

Central-government officials have expressed alarm and (ineffectually) reminded local governments that resettlement must be voluntary. Beijing newspapers have run several exposés of the horrors of being “upstairsed”, comparing the phenomenon to Britain’s enclosure movement of the 18th and 19th centuries when landlords stripped farmers of their right to use common land. Last September Xinmin Evening News, a Shanghai newspaper, described cracks in Chaobei New City’s buildings, flooded basements, sagging ceilings and a leaky sewage system.

Angry victims of forced appropriations are legion. According to state-controlled media, seizures of rural land by local governments are the cause of 60% of mass petitionings in China and of nearly 4m disputes every year. Lynette Ong of the University of Toronto says almost all compulsory relocations involve gangs or secret societies, often hired by local governments to push farmers out. Occasionally evictions trigger large-scale protests, but strong-arm tactics usually deter farmers from putting up much resistance. The thuggery, often brought to light by social media, is a political embarrassment to the central government. But what is behind these land grabs is of far greater concern: a financial system that has gone wrong and a system of local governance that has become dangerously dysfunctional.

Chaobei New City is symptomatic of both. The local government sold ten hectares (25 acres) of the land seized from the villagers to a local developer, Xiu Lan Real Estate Group. The company is using it to build Rivedroite Town, a cluster of lavish French-style houses separated by a wide road from the farmers’ new flats. It is unclear how much Xiu Lan is investing or where the money is coming from, but the company’s website suggests it has a close relationship with large state-owned trust companies. Such institutions are a widespread and openly acknowledged source of financing for property projects. Their lending is less strictly regulated than that of formal banks. A cosy relationship between both types of institution has enabled what Stephen Green of Standard Chartered calls “shadowy activity” by formal banks, which use their informal counterparts to channel lending into property and other risky projects.

Some trust companies and banks raise funds by selling fixed-term investments known as wealth-management products (WMPs). These promise better returns than bank deposits, interest rates on which are capped at extremely low or even negative real levels—a legacy of Maoist banking that has proved hard to shake off. But this short-term finance often supports long-term projects, creating a dangerous maturity mismatch. And some institutions may be repaying maturing products with fresh funds raised from new ones. In 2012 Xiao Gang, then chairman of the state-owned Bank of China and now in charge of regulating the country’s stockmarkets, described this as “to some extent…a Ponzi scheme”.

In theory banks are not liable when WMPs go wrong. In practice, when defaults have occasionally loomed, ways are almost always found of keeping investors from losing much, if anything (including in the biggest potential default so far, of a $490m trust product issued through China’s biggest bank, ICBC, that was due to mature in January; a stalled mining venture related to the project suddenly got official permission to go ahead).

Local governments, which in China cannot borrow from formal banks or sell municipal bonds without central-government backing, are among the biggest borrowers through such shadow channels. They mostly use the money to finance public works (including knocking down villages in the hope that resulting “urbanisation” might stimulate growth). In response to the global financial crisis of 2008 the central government loosened controls on bank lending. The volume of new loans doubled in 2009. Much of the money found its way indirectly into the hands of local governments which used it in a spending binge in an effort to maintain growth. As a result, debts soared. Along with WMPs, this has become the biggest worry to bearish observers of China’s economy.

There are good reasons for concern about local-government borrowing, and about the banks and trust firms, but financial meltdown looks unlikely. An audit made public in December showed that in mid-2013 local governments directly owed 10.9 trillion yuan ($1.8 trillion), an increase of more than 60% on 2010. This is by no means crippling. Taken together with other debts for which local governments are, or might be, liable, such as those of local state-owned enterprises, it amounts to one-third of GDP. The central government would never allow a local government to default, so these debts are for the centre to worry about. GK Dragonomics, a research firm, says total government debt may be 70-80% of GDP, still well below the levels of many rich countries with lower growth.

Risks are certainly growing. Standard & Poor’s, a credit-rating agency, points out that projects which once looked viable may cease being so as growth slows. It outlines a possible scenario: a WMP fails, investors stop buying new products and non-bank credit dries up. Investment slows and property prices drop. Non-performing loans rise, putting pressure on banks. Credit slows further, and growth with it. In the event of such a crisis, however, the central government could take bad loans off the banks’ books and order them to resume lending. It could also ramp up its own spending. It would not solve the problem, but could avert an immediate crisis.

To reduce such risks, China must introduce a range of reforms. The most pressing of these is to lift controls on bank-deposit interest, which would reduce depositors’ incentives to shift money into riskier WMPs. There are signs that it is gradually moving that way, but for all the recent talk of the importance of markets, progress remains slow. Zhou Xiaochuan, the governor of China’s central bank, in March held out the possibility of full liberalisation of interest rates in a year or two. Banks themselves are not keen because higher rates would cut their profit margins.

Local governments receive half the nation’s fiscal revenue but are responsible for 80% of spending

Reform is also slow in two areas that are key to local governments’ woes: the way in which their spending obligations, such as on public works, are funded; and the ownership of rural land. Changes in both are vital if China’s new “human-centred” urbanisation is to succeed and officials’ rapacious instinct to grab land is to be tamed.

Local governments’ lack of money to cover their spending needs is a problem of the Communist Party’s own making. In 1994, worried about the central government’s rapidly declining share of the country’s total revenue, the party reorganised the tax system to boost the centre’s takings. But it failed to reduce the burden on local governments, which have remained responsible for such coffer-draining activities as providing education and health care. The central government transfers funds to local ones (via provincial governments) to cover basic costs, but this is often far from enough. Local governments receive half of the nation’s fiscal revenue but are responsible for 80% of spending.

To make up shortfalls, local officials turn to rural land. Whereas the property rights of urbanites were strengthened from the late 1990s, thanks to the privatisation of urban housing and legislation to protect it from government interference, the property rights of villagers have remained vulnerable to abuse. Landesa Rural Development Institute, an American NGO, found that in 1,791 villages it surveyed, the number of land seizures had nearly tripled between 2007 and 2011. Land-related income, which in 2001 made up one-sixth of local-government revenue, had soared to three-quarters a decade later.

Counting the cost

Giving urban benefits to migrants will cost a lot of money. Unless a new way of funding local governments can be found, they are likely to solve the problem in the time-honoured manner: by seizing yet more land. The central government might help, but could it afford to? Estimates of the likely expense vary widely. A report this year by the Chinese Academy of Social Sciences put the cost of providing a migrant worker with full urban benefits at 130,000 yuan. A government study in 2010 came up with a figure of 80,000 yuan. But Kam Wing Chan of the University of Washington writes that even at about 100,000 yuan per migrant, the total would still be manageable.

Mr Chan calculates that it would add up to around 23 trillion yuan, or more than 44% of China’s GDP in 2012. That would be more than any economy could cope with, but it would not happen all at once. If it were done gradually, bringing in 20m migrants annually, it would mean spending a far more manageable 3.8% of 2012 GDP a year. But in fact those 100,000 yuan of health-care and other expenses would be stretched out over a lifetime, so the actual annual cost of converting 20m people to full urbanite status would be 0.1% of 2013 GDP, Mr Chan reckons: about one-fifth of what China spent on the 2008 Olympic games.

That would leave the task of giving full property rights to farmers. Doing so would make it more difficult for local governments to seize land, which in turn would make it harder for them to find ready collateral for piling up huge debts. Most importantly, it would empower farmers, and perhaps even end the tyranny of village officials who use their control over land to fill their pockets. Last November the party pledged to allow rural land (though not arable land) to enter the market on the same terms as any other property. This will take time: even deciding who owns what in the countryside will be tricky. And local governments are not keen to dispense with a ready source of cash.

But the party has to press ahead. If financial and social stability are not sufficiently powerful incentives, there is another to consider: the rampant urban sprawl encouraged by local governments’ ability to seize rural land at will. Such unrestrained expansion may work in parts of America where there is plenty of empty land (albeit at a cost to the environment and often to the quality of life). In China, where urbanisation has forced around 40m farmers off their land over the past three decades, usually with little or no compensation, it will not.