Recently, the paper “Land Finance and Chinese Macroeconomic Fluctuations”, written by Chan WANG, assistant professor of the School of Finance, Dr. Fuyang ZHAO and Professor Liutang GONG of Guanghua School of Management, Peking University, was published in the 12th issue of “Economic Research Journal” in 2017.
Summary: In the four years after the financial crisis, from 2008 to 2011, China kept its GDP growth rates above 9%, rose to become the world’s second largest economy, and joined the club of upper-middle income countries. So, what made China an outlier in the post-crisis period?
The behavior of Chinese local governments has become increasingly notable． First, we observe strong positive comovements between infrastructure investment and residential land prices． In 1994, tax reform caused the centralization of tax revenue and the decentralization of authority. Afterward, Chinese local governments started to undertake greater burdens of local economic development and urbanization. As a main part of the task, infrastructure investment has become an increasing obligation for local governments. At the same time, the centralization of tax revenue reduced budgetary fiscal revenue significantly but left land-related revenues to local governments as non-budgetary fiscal revenue. After the housing commercialization reform in 1998,and a primary development of urbanization, the value of urban land has been largely revalued, leading local governments to rely more and more on the land-transferring fees to finance their public expenditure, especially the infrastructure investment. This behavior is general referred as“land finance”,and has been more notable since the central government’s monetary and fiscal stimuli in response to the subprime crisis.
Chinese data reveals more about land finance behavior. First, there is a substantial difference between residential land prices and industrial land prices. Industrial land prices have been much lower and less volatile. Second, local governments’ tax revenue from firms is negatively correlated with residential land price and infrastructure investment, which is a countercyclical phenomenon of local taxation. We believe land finance is an important factor in China’s high-speed growth in the post-crisis period. However, quantitative studies on this topic in a general equilibrium framework have been scant.
To understand and replicate the salient features of land finance, we build a DSGE model by introducing local governments’ behaviors into Liu et al.‘s ( 2013 ) model. Unlike the literature treating governments’ behaviors as exogenous shocks and that treating governments as competitive sectors holding partial knowledge, our model treats the local government as the leader in a Stackelberg equilibrium. The government solves the Ramsey problem by choosing the optimal levels of the tax rate, infrastructure investment, and land supply in two land markets. To give the government an incentive to provide infrastructure investment, we assume that infrastructure investment has positive externalities to private production and that infrastructure investment enters the government’s objective function. Because Chinese local governments have strong monopoly power in the elementary land market, we also assume that the land market is separate for households and firms, so there are differentiated residential and industrial land prices in our model.
The mechanism of our model is as follows. When a positive shock to housing demand occurs, the local government adjusts residential land supply and raises the residential land price to relax the budget constraint, which increases infrastructure investment and decreases the tax rate. The local government also suppresses the increase in the industrial land price to guarantee the promotion of private production. Because of the complementarity between the factors in production, the marginal products of private investment and labor employment rise, and demand for private investment and labor employment thus increases. Furthermore, because the total land supply is exogenously limited, local governments’ attempts to control the rise of the industrial land price tightens the supply of residential land. In addition, the rise in wage causes a wealth effect that further increases the demand for residential land. Thus, a financial spiral is set off that drives the fluctuations in major macroeconomic variables as described following the initial shock to housing demand.
Keywords: Land Finance; Infrastructure Investment; Differentiated Land Prices; Macroeconomic Fluctuations
