China's cities are running out of cash to pay huge Covid lockdown bills

Hong Kong(CNN Business) Protests this week across China show just how unpopular Beijing's zero-Covid policy has become. Now, even as the country signals it may loosen pandemic controls, it faces another challenge: Local governments charged with conducting mass testing and enforcing quarantine are running short of cash and could be forced to cut corners or reduce other vital services.

The zero-Covid policy kept China out of recession in 2020. But nearly three years on, the bills are mounting, placing an extraordinary financial strain on municipal authorities across the world's most populous nation.

If lockdowns and mass testing persist, "the financial stability risks will increase," George Magnus, an associate at the China Centre at Oxford University, told CNN Business.

"Local governments are under huge pressure from the cost of maintaining zero-Covid, and we can already see this in the debt sustainability of several entities and [in] instances where public services are being scaled back, local assets or services sold and so on."

Local governments, whose revenues rely heavily on land sales, are more vulnerable than the central government. They spent 11.8 trillion yuan ($1.65 trillion) more than they raised in revenue between January and October, borrowing heavily to do so, according to data from China's Ministry of Finance.

Ballooning government debt poses a direct threat to China's economic health. It not only increases the risk that municipalities will default on their debts, but also squeezes the government's ability to spur growth, stabilize employment, and expand public services.

'Widest in history'

For nearly three years, local governments have borne the brunt of enforcing pandemic controls. They have had to pay for regular mass testing, mandatory quarantine stays, and other services during frequent lockdowns, resulting in soaring expenditures even as income has stagnated.

But they face revenue shortfalls relative to their spending needs. They account for half of general government revenues, but make up over 85% of general government expenditures, according to analysts.

DBRS Morningstar, a Toronto-based global credit rating agency, said earlier this month that local governments' high deficits were a key concern, including so-called "hidden debt" from special financing tools meant to boost funding for regional governments in the first place.

Some of this debt is never officially acknowledged on government balance sheets.

"Higher deficits and lower nominal GDP growth are expected to result in China's general government debt rising to 50.6% of GDP in 2022," significantly higher than the 38.1% in the pre-pandemic year of 2019, they said.

That would still be relatively low by global standards. But it would represent a historic high for China.

The weak fiscal position of local governments has been a drag on the country's overall financial standing.

China's broad fiscal deficit, which amalgamates deficits for both the central and local governments, hit 6.66 trillion yuan ($944 billion) in the first ten months of 2022, nearly tripling from a year ago, according to CNN Business calculations based on data from the Ministry of Finance.

Zhao Wei, chief economist at Shanghai-based Sinolink Securities, estimates that the broad fiscal deficit could surpass 10 trillion yuan ($1.4 trillion) in 2022, the widest in history.

Low income, high costs

Why are local governments in this parlous state? In previous years, their spending had been funded by land sales, which have typically accounted for more than 40% of their total income.

But a slump in the housing market has cut into that funding. For the first ten months of 2022, land sales tumbled 26% from a year earlier and are on track for their first decline in seven years because of a plunge in demand from developers reeling from a collapse in home sales.

Local government finances are also being stretched by a sharp contraction in revenue as feeble economic growth and huge tax breaks for businesses reduce income.

More than 3.7 trillion yuan ($524 billion) of tax breaks have been given this year to businesses hit hard by the pandemic. Meanwhile, China's economy only grew by 3% in the first three quarters of this year.

At the same time, the costs associated with Covid testing are massive. Covid-related healthcare spending jumped 13% to hit 1.75 trillion yuan ($245 billion) in the first ten months of 2022, the biggest surge among all types of government spending, official data showed.

From the beginning of the pandemic through April 2022, 11.5 billion tests have been conducted in China, according to the government. But the actual number may be much higher.

Analysts from Soochow Securities estimate that 10.8 billion tests have been conducted in April to June alone, suggesting a huge increase in the amount of testing.

They believe the cost of Covid testing could run as high as $240 billion a year, if half a billion people in China's large- and medium-sized cities were tested every two days. In May, Beijing told local governments that they had to bear the costs for regular Covid testing in their regions.

No payment

Strapped for cash, many cities across the country, including those in the provinces of Sichuan and Gansu, have asked residents to pay for testing themselves, even though proof of a negative Covid test is still required to enter public venues or transport.

"China is sinking deeper into a 'who will pay?' morass," said Magnus. "Somehow the local government sector is going to have to cope, perhaps poorly, but unless Beijing makes the money available, this is the way it'll be."

The lack of money has already prompted some local authorities to delay or suspend payments to Covid testing providers.

In the first nine months of this year, 15 of China's biggest listed virus testing providers reported a combined 44 billion yuan ($6.15 billion) in accounts receivables or unpaid bills, up 71% from a year ago, according to data compiled by a unit of China Finance Online, a financial information service provider.

Some labs have even suspended services. Earlier this month, a Covid testing lab in the central province of Henan province said it had to halt testing because local authorities hadn't paid any bills since January 2021.

End to zero-Covid?

Despite soaring infection rates, there are signs that some cities are now easing Covid restrictions following a series of protests across the country over the past week.

The southern city of Guangzhou announced Wednesday that it would lift lockdown measures in key districts, after people clashed with police demonstrations against overly restrictive restrictions. The southwestern city of Chongqing also eased Covid curbs on the same day.

Vice Premier Sun Chunlan, who is responsible for public health affairs, said Wednesday that China was in "a new stage" of fight against Covid 19.

The country may still be a long way from ending its zero-Covid policy completely. Vaccination rates among the elderly and hospital capacity need to improve, according to Sun.

While the huge costs associated with zero-Covid are not financially sustainable, the policy is likely to continue so long as protests remain isolated and sporadic, said Craig Singleton, senior fellow at the Foundation for Defense of Democracies, a Washington-based think tank, adding that local authorities may still rely on Covid restrictions to limit any surge in cases.

Local governments have been under pressure to prevent outbreaks. Officials who have failed have been penalized, creating the potential for disconnect between a tone shift from the central government and the reality on the ground

"Politics is supreme," said Andy Xie, an independent economist. "Local governments must find money for zero-Covid. They can cut spending elsewhere. Otherwise they will be sacked."

Correction: An earlier version of this article gave an incorrect dollar figure for China's projected fiscal deficit in 2022.