Reform is a series of choices. However, regarding which choice has really changed the history, it could not always be seen clearly at that time. This is true with “land finance”. From birth to formation, it didn’t have a complete design. Even the term “land finance” came out only later. But it’s exactly such “land finance” of unclear origin, unattended and even not strictly defined that has caused an unprecedented change in the landscape of Chinese cities, and has even become the root of global economic success and problems.

“Land finance” is the core of China’s distinctive development path. Is this model sustainable? Can it still be improved? Or completely given up? This is a major choice vital to the state’s destiny. However, as “land finance” is kidnapped by such sensitive social topics as “housing prices”, “corruption” and “bubbles”, abandoning “land finance” has almost become a one-sided consensus of academia and social media. An objective, professional academic discussion that ought to be, has evolved as a contest of criticizing “land finance”.

Good “academic research” lies not in teaching people of “common sense” that everyone knows, but in that it can explain “abnormalities” that no one understands. The reason why “land finance” can stand against criticism is that it has an intrinsic logic unknown to the academia. This article attempts to, following the main line of “credit”, re-evaluate the merits and demerits of “land finance”, think about risks that might be brought by completely abandoning “land finance”, and explore feasible paths to improve “land finance”.

1. Properly evaluate the merits and demerits of land finance

1.1 Credit: catalyst of urbanization

City has existed for several thousand years with ups and downs, but why an irreversible “urbanization” suddenly appeared in modern times? The vast majority of research has held that, urbanization is a result of industrialization. This superficial explanation has hampered our knowledge about the underlying cause of urbanization.

A city is characterized by its ability to provide public services that are unavailable in rural areas. Public services are the only source of urban land value. The value of urban real estate, fundamentally, is a projection of public services in its location. No matter city walls, roads or diversion works, all the public services require an extensive one-off investment (fixed cost). In the traditional economy, such one-off investment is obtained mainly through the past accumulation. This has significantly restricted the construction of large-scale public facilities. The huge one-off investment of infrastructure facilities has become a main obstacle against urban development.

Groundbreaking progress came from credit system innovation in modern times. Through the credit system, future earnings can be discounted to today, enabling the formation mode of capital to get rid of reliance upon the past accumulation and move toward expected earnings. The credit system has provided a possibility for large-scale, long-cycle equipment and infrastructure investment. The combination of technological advance and credit system has jointly launched urbanization and industrialization, making the latter two become accompanying economic phenomenon.

Capital can be mortgaged by capital only [i]. The key of credit system is how to obtain “initial credit”. The launch of both industrialization and urbanization must cross the critical threshold of original capital. The original capital (infrastructure) accumulation, once completed, would bring sustained tax income, which can be re-mortgaged or re-invested for self-circulation to accelerate accumulation.

A choice of urbanization model, at bottom, is a choice of capital accumulation model. Different original capital accumulation methods have determined different urbanization models. History has indicated that, if relying completely upon internal accumulation, it would be very hard to cross the minimum original capital threshold. If forcing to accumulate, a mass-scale social turmoil might be triggered. Therefore, the original capital accumulation of early capitalism, to a great extent, was completed through external plunder. Almost each of developed countries can be traced back to the “original sin” at the early stage of its urbanization.

The traditional Chinese social relations is a typical differential pattern (Fei Xiaotong, 1985), with private credit to a great extent limited to acquaintance society, so it can only have a small scale and a short cycle. In modern times, after China’s door was forced to open, instead of completing the original capital accumulation, China became a source of original capital accumulation by big powers. After 1949, China regained full tax sovereignty, but the external environment of relying upon plunder to realize original capital accumulation no longer existed. China had to move toward the planned economy model.

The so-called “planned economy”, in essence is still a model of forcing to complete original capital accumulation through self-transfusion. Under the condition of planned economy, economy is classified into agriculture and industry, and the state, via price scissors of industrial and agricultural products, kept transferring the agricultural accumulation to the industrial sector. With this method, China established a preliminary industrial base, but had no energy left for completing the accumulation of urbanization. The ultra-strong accumulation choked the Chinese economy, making production and consumption unable to realize effective circulation. Before the reform, China’s urbanization level had been hovering around more than ten percent.

1.2 Land finance: “initial credit” of China’s urbanization

The big breakthrough of China’s urbanization model started in late 1980s. At that time, the model of relying upon the agricultural sector to provide accumulation for China’s industrialization had become hard to sustain, and special economic zones, including Shenzhen and Xiamen, were forced to imitate Hong Kong with an attempt to finance for infrastructure construction through transfer of urban land use rights, so that a unique road of accumulating original capital for urbanization with land as credit basis was created. This is “land finance” widely reviled later.

The tax-sharing system reform in 1994 significantly compressed the tax sharing ratio of local governments, but the allocation of land revenue with a very small scale at that time to local governments has laid an institutional foundation for local governments walking toward “land finance”.

With a series of institutional innovation such as the housing system reform (“city stock listing”) in 1998 and the land remising (seller determined market) in 2003, “land finance” kept improving. Local governments with big reduction of tax sharing, instead of fall, became rich suddenly. The rapidly expanding “land finance” helped governments accumulate original capital at an unprecedented speed. Urban infrastructure not only gradually paid off the debt, and part thereof even went beyond (high-speed rail, airport, administration center). Hundreds of cities were rising overwhelmingly. Both the speed and the scale of urbanization had exceeded the boldest imagination at the beginning of reform. Observed from the perspective of human history, such rapid growth can only be described as amazing.

Indeed, if without “land finance”, many problems of the Chinese economy today would not appear, but likewise, there might be no such rapid development of China’s urbanization today. The real secret behind great achievements of Chinese cities is that a system with land as credit basis, i.e. “land finance”, has been creatively developed. It can be said that, if without such great institutional innovation, the urbanization road with Chinese characteristics is meaningless.

Why can China walk on this road? This is because the urban land nationalization and rural land collectivization established by planned economy has created conditions for government monopoly of primary land market. The role of “land finance” is using the market mechanism to convert such hidden wealth into huge capital for launching China’s urbanization (Zhu Yunhan, 2012).

“Land finance” is not patented by China. Over nearly a century from its founding to 1862, the Federal Government of the United States also relied upon “land finance”. Unlike the old continent of land privatization, colonists took away large areas of land from the hands of indigenous people almost free of charge. According to the federal law at that time, all of the newly expanded land of founding thirteen states and the land within newly joining states were owned, managed and controlled by the federal government. Public land revenue and tariff constituted the most important part of federal revenue. Land sales revenue accounted for a maximum of 48% in the federal government’s revenue.

By contrast to China’s land finance, we can imagine how big the land finance scale of the United States was at that time. In 2012, China’s national tax revenue was 11 trillion, equivalent to 5 trillion if calculated by 48%, while the gross revenue of “land finance” in 2012 was less than 2.7 trillion. China’s land finance has a history of 20+ years only even if calculated from early 1990s, while in the United States, it has lasted nearly one hundred years from the nation’s founding to 1862 when Home Stead Act required land transfer to new migrants free of charge. After 1862, land finance of the federal government was gradually replaced by property tax of local governments.

1.3 The essence of land finance is financing rather than income

In a city of land privatization, any improvement of public services must be transferred to land owners by way of real estate appreciation. The government can only, through the tax system, recover these overflowing incomes. The efficiency of tax finance almost entirely depends on the game with taxpayers. The interest leakage brought by system loss is extremely high. Under the condition of public land ownership, any improvement of public services will overflow to state-owned land. The government can, with no need of tortuous tax practices, directly recover the benefits brought by public services from land appreciation. Relative to the “taxation” way, the efficiency of recovering public service investment by “selling land appreciation” is so high that the city’s government not only can finance for infrastructure, but even can, by way of subsidy, finance for projects with continued tax.

This unique system left by planned economy makes land become a huge and constantly appreciating credit source for China’s local governments. Different from western countries’ practice of mortgaging tax for issuance of municipal bonds, the essence of China’s land revenue is one-off investment/financing for urban public services by selling future appreciation of land (70 years). The essence of Chinese urban governments is directly selling future public services. If treating any urban government as an enterprise, then western countries’ cities are financing by issuing bonds, while Chinese cities are financing by issuing “stocks”.

Therefore, in China, if a resident buys a city’s real estate, it will be equivalent to buying the city’s “stock”. This explains why Chinese residence has such a high yield – because the essence of Chinese residence is a capital product, which, in addition to living, can also provide dividends – not only sharing the rental value of current public services, but also sharing the rental value brought by future new services! Hence, Chinese housing prices and foreign housing prices are two completely different concepts – the former itself carries public services, while the latter needs to purchase public services.

In this sense, the term “land finance” is fundamentally misleading – land revenue is financing (stock), rather than fiscal revenue (tax). In the balance sheet of a city’s government, land revenue is put under “liabilities”, while tax is put under “earnings”, so “land money” might be a description closer to the essence of land revenue than “land finance”.

The understanding of “land finance” is helpful for explaining an “abnormality” that has puzzled economists – why the Chinese economy shows rapid growth, while the stock market has been depressed for a long time. If regarding the housing prices of different cities as the stock prices of these “city companies”, you will find that the growth rate of China’s stock market is identical with that of China’s economy, not abnormal at all. As the financing efficiency of land market is far greater than stock market, many sectors would, by virtue of local governments attracting investments, carry out financing activities through land market by way of tie-in sale.

Although it’s very hard to directly observe the difference of land finance relative to tax finance, we can still make comparison indirectly based on some data.

In recent years, China’s M2 has continued high growth, but not triggering the super inflation expected by economists. An important reason is that, the M2 scale is supported by actual demand. Presently, a popular practice is to compare M2 and GDP. In 2012, the M2 balance was 97.42 trillion, while GDP was approximately 51 trillion; the ratio of M2 and GDP reached 190%. It’s held that, the M2/GDP data rising year by year, indicates the capital efficiency and the efficiency of financial institutions are lower. Some people are even concerned about inflation return and housing price rebound.

However, practice has shown that, there is no strict correspondence between M2 and GDP. The year of 1996 was a watershed. From this year, M2 began to exceed GDP, but later, it kept a low inflation for a long time, and even deflation during some times. All of big inflations after the reform and opening up appeared before that. This is because, a desirable currency issuance scale depends on the credit behind currency, rather than GDP itself. If we say there is a positive correlation between tax finance credit and GDP, the relevance of credit provided by land finance and GDP might be multiplied than tax finance of the same GDP.

After the disassembly of “Bretton Woods System”, most currencies of the world, previously anchored at gold, were on floating. The US dollar, by linking with commodities especially oil, re-found its “anchor”, making the US dollar able to, through commodity price hike, digest the inflation pressure brought by excess currency issuance. Euro attempted to find an “anchor” with carbon trading as the benchmark, and has not succeeded yet so far. Yen is basically anchored at the US dollar, and thus must keep hoarding dollars on a massive basis. Excess currency issuance can only rely upon US dollar appreciation for digestion.

“Land finance” gives RMB an “anchor”. Land becomes the currency benchmark, and provides a cornerstone for China’s currency autonomy. In 2013, when FED announced it would gradually withdraw from “quantitative easing”, emerging market countries immediately saw capital outflows, currency devaluation and exchange rate fluctuation, while RMB’s exchange rate was standing firm. This indicates that RMB has broken off the US dollar pricing and found its endogenous “anchor”, i.e. real estate: with real estate appreciation, currency issuance should rise accordingly, otherwise, deflation would occur; if currency increases, while real estate is devalued, inflation would be inevitable. In other words, excess currency issuance must be absorbed by real estate appreciation, otherwise, excess liquidity would cause inflation.

Although the housing system reform in 1998 didn’t increase GDP, it enabled “city stocks” to get formally “listed for circulation”, leading to a rapid expansion of credit demand across the society. If understanding the essence of housing prices is stock prices, we would know that, the reason why inflation fails to come as scheduled is that the housing price hike has caused the all-society credit scale to expand faster than currency.

1.4 “Land finance” is the institutional foundation for China’s peaceful rise

The history of economic risk in western countries has shown that, tax finance of lower efficiency cannot fully satisfy the demand of original capital at the stage of urbanization launch. To avoid domestic political pressure, external colonial expansion and invasion has become a shortcut for most of developed countries to quickly complete accumulation. This is why China’s previous development model would certainly bring expansion and conquer, as new rising countries must have collisions and conflicts with countries that have risen. If we cannot give a convincing explanation in respect of development model, but just rely on the repeated statement of our desire for peace, it is hard to make other countries believe that the rise of China will be an exception.

Some people hold that, international trade and investment at the times of globalization can help developing countries choose an external accumulation model of not conquering by force of arms. Although this theory comes from western countries, they themselves don’t really believe it. Otherwise, their action of deliberately blocking Chinese investment and trade cannot be explained. Indeed, after the war, some isolated economies, under special political conditions, have completed the original capital accumulation relying upon international trade and investment, but it doesn’t mean that such a large-scale economy as China can also replicate this development model.

The history of opening during the late Qing dynasty and the Republican period has shown that, the benefits of market opening to both transaction sides are not as unconditional as specified in the theory of “competitive advantage”. International investment and trade can help Chinese enterprises acquire market share worldwide, but also has opened the door to economic colonization of international capital, with advantages or disadvantages and gains or losses depending on the capital strength of the two sides – globalization is favorable only for the side with stronger competitiveness. Why has the economy of developed countries stood on the more competitive side for a long time? An important reason is that, its well-established “tax-finance” system can support financing with very high efficiency, so as to obtain the global competition advantage. Therefore, under normal conditions, countries of the most abundant capital generally would give the most powerful impetus to globalization.

However, China’s “land finance” has broken this role by, within just 10+ years, creating a more efficient financing model than western countries. By virtue of strong credit based on “land finance”, China not only has its products sold across the globe, but also surprisingly becomes a big capital power that can advance shoulder to shoulder with other big powers.

Anti-dumping has always been an economic tool for developed countries to deal with other more developed countries, but now is used for dealing with developing countries such as China; previously, countries of rapid urbanization would experience a shortage of capital, and countries of completed urbanization would have capital surplus, but now it’s on the contrary, i.e. China is exporting capital to developed countries. Behind these “anti-economic common sense” phenomena, the super high efficiency of “land finance” is actually reflected.

The true reason for China’s ability to realize “peaceful rise” is exactly that, the “land finance” model enables China to, without by way of external conquer, obtain “initial credit” required for original accumulation. The efficient capital formation has relieved the credit hunger at the stage of original capital accumulation, and has ensured China’s economy becomes the party benefiting from opening and globalization. Therefore, even at the initial stage of urbanization with a lower development level, China has a greater hope to maintain the current economic order than any other country, and is more motivated to drive economic globalization. The success of land finance has ensured “peaceful rise” becomes a built-in option of the Chinese model.

Zhao Yanjing, Professor, School of Civil and Architecture Engineering, School of Economics, Xiamen University (article fromUrban Development Research, Volume 21, Issue 1, 2014)