Throughout China’s history as an agrarian country, land has been the source of life for the masses. Dynasties have risen and fallen based on their ability to effectively provide land for the people. No one is more aware of the importance of land allocation than the ruling Communist Party, which rose to power by promising land reform (to more equally distribute it) to its rural base of supporters.

As China continues its transition from an agrarian to an industrial society, the rapidly growing economy has gobbled up former farmlands, displacing both the produce and the farmers who farmed it. Arable land has always been a constraint for China, and the loss of food supply, an increase in angry farmers, and the risk of a runaway economy have forced the central government to move to take control of the land allocation process in ways that have important consequences for foreign investors.

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The Chinese government has enormous sway over land issues because land cannot be privately owned. Ownership is either held by a ‘collective’ for agricultural use, or by the state, which grants land-use rights to private parties for non-agricultural purposes (typically for a 50-year term).

The land is also zoned according to the Land Utilisation Master Plan and the Annual Land Utilisation Plan. Land can be classified in the plans as either ‘construction-use land’ or ‘agriculture-use land’. Construction-use land is further zoned into categories such as commercial or industrial. Only land that is state-owned and zoned for construction use and industrial use may legally be used for industrial investment.

The quota system

When an investor wishes to use a plot of land that does not meet the planning and title requirements, which is often the case because most development takes place in urban fringes that were recently or are still being farmed, the local land bureau must go through a process to convert the ownership to state-owned and change the planning to construction use. To do so, the local government must have enough quota, which is originated by the central government and is passed down through lower level governments and regulates the amount of agriculture-use land that can be converted each year.

With the quota available, the land bureau has to apply to convert the land ownership and planning status. Once that is complete, the local land bureau must administer a bidding or auction process before it can finally grant the land-use rights to the investor. If the quota is available, this process usually takes between six months and a year.

However, the quota has become the central government’s first line of attack in limiting land supply for industrial use. Provincial-level land administration officials confirm that the total national quota has been decreasing or stayed flat in each of the past few years and the tightening trend is certain to continue. As the quota tightening trickles down to local governments, it is becoming harder for line officials to convert land from agricultural use.

In many localities, there is a long backlog of land waiting for quota to be converted to state-owned. Quota is allocated once a year and if there is not enough to go around, an investor may have to wait another year or two before it is their turn. When adding the time to get quota with the regular processing time, it can now take years instead of months before land-use rights can be granted on a plot.

Instead of waiting, many companies, including foreign multinationals, have chosen to take occupancy of collective-owned, agriculture-use land before the process to convert it is complete. With the co-operation and encouragement of local government, these investors often begin construction and operations without any legal rights to the land.

In a survey of four publicly traded foreign investors in a fourth-tier city in Jiangsu province, none of them were able to obtain land that was already state-owned construction use. Two companies went ahead and built their facilities illegally and eventually obtained their land-use rights after they began construction. These companies were aware of the legal issues, but generally felt that their relationships with the local officials mitigated any risks.

The third company took occupancy of agriculture-use land, but did so without being fully aware that it was illegal. The fourth company had a policy that it would not conduct itself in any manner that was a violation of the law and decided to not invest until it could find a plot of land that it could legally use, which delayed its project by about a year.

Legal price

While the companies that violate the law by manufacturing on agriculture-use land did not fear repercussions for doing so, the central government has stepped up enforcement efforts to add some weight behind the policies. Under the land law, the remedy for illegal land usage is usually to remove the occupier, demolish the buildings and assess fines. The local officials responsible for allowing such projects to move forward have also been taken to task through dismissal and sometimes even jail. A local land bureau official who helped one of the surveyed companies start illegal construction was recently sentenced to a 12-year prison term for various abuses of land policy.

To enforce these rules, the State Council set up a land supervision system in 2006 with a mandate to stem the illegal usage of agricultural land. At the end of 2007, the authorities launched a 100-day campaign that brought more than 30,000 cases against illegal land users involving 2.2 billion square metres of land. Of these cases, a total of 14 million square metres of facilities were confiscated and 7.7 million square metres were demolished. Though none of these cases were known to be foreign companies, the enforcement efforts are only getting more active and there is no guarantee that multinationals will not be targeted in the future.

Many investors who look to lease a facility in many parts of China face an immature leasing market where most available facilities are actually built on agriculture-use land that the landlords cannot convert to state-owned. These investors often make the mistake of assuming that as a tenant, the risk of leasing an illegally built facility is limited to that of having to move if any of the land ownership problems occur. However, a problem that these tenants often fail to consider is that if the landlord does not legally have the rights to the land, then the lease on the facility is not a legally valid contract. Such a situation is equivalent to operating without a lease contract in place and all the risks that come with it.

The quota restrictions are disproportionately affecting areas in the relatively less developed areas such as the west and north-east. Whereas the economic centres on the eastern seaboard have been developing for more than two decades and have had time to build up their stock of industrial land when land policies were lax, other areas have seen the demand for investment and land pick up more recently just as land quota restrictions have been increasing.

The decrease in supply of land that is properly zoned and titled for industrial use is causing companies to face the choice of either illegally occupying land or putting the project on hold until an acceptable plot of land becomes available, neither of which is palatable.

The first thing that a foreign investor can do to mitigate these issues is to keep its options open when locating the project. These investors should cast a wider net in site selection and be willing to consider locations outside of their original plan. The additional options will increase the probability of finding land that is legally compliant while also creating competitive pressures on the local governments to do their best to meet the investor’s requirements.

Repossession policy

During negotiations, the investor can press the local government to make firm commitments on the land conversion timing, such as putting the company at the front of the line for access to the quota. The commitments should have short deadlines so that the investor can quickly pull out at the first sign that the government will be unable to perform.

Investors should also consider that another facet of the tighter land policy is that the government is also repossessing a significant amount of unused land. Unused land is land that was granted to an investor but has been left undeveloped or underdeveloped for more than two years. The government has the right to take back such land and grant it to a new investor, but will often engineer a transfer from the current land user to a new investor to achieve the same effect of rationalising land usage. As such land should already be legally set up for industrial investment, it could be an effective and quick way to acquire land.

The tightening land policy is part of the Chinese government’s efforts, along with the new labour law and revised tax policy, to provide more balance between economic growth and a stable society. Through uneven enforcement and ambiguous interpretation, these policies are making China a more challenging place to invest.

James Ku is a manager and Amanda Zheng is a research analyst with Tractus Asia, a consulting firm that advises multinational companies in strategies for making direct investments in Asia.