Does Local Government Debt Have Chinese Economy by the Throat?

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XIYUAN HU's picture

Does Local Government Debt Have Chinese Economy by the Throat?

As the bright spot in the world economy after the financial crisis swept the global markets in 2008, China was called on by various organizations and individuals to save the US and Eurozone area. However, emerging domestic challenges like high inflation and manufacturing enterprises' survival dilemma make people rethink about China's ability in acting as the savior of the world. Among those problems, the possibility of China defaulting on local government debts causes huge concern recently. Is local government debt a serious threat to the whole economy now? That is the question we are going to explore in this article.

Review on the local government debt problem

In April 2011, a road development and investment company of Yunnan Province, which in essence is a financial platform for local government to borrow money, mailed letters to its creditor banks saying that from now on it would only pay interest back to the banks without paying the principle. This zombie debtor's defaulting behavior together with other similar events led to an unimaginable shock in Chinese financial market.

Aware of the seriousness of local debt problem, central government sped up the investigation of financial platforms and all other forms of local government debts. On June 27th of 2011, National Audit Office published the total amount of local government debts in 2010, which is as large as 10.7 trillion yuan. According to the report, among all the provincial, municipal and county-level governments, only 54 out of 2779 county-level governments do not borrow any money. Local governments mainly use financial platforms which usually function in the form of state-owned companies to borrow money, and about 80 percent of the debts are bank loans. Concerning the repayment, local governments need to pay back 24.49% and 17.17% of the total debts in 2011 and 2012 respectively. The most recent news indicated that regulatory department and banks are considering a conditional roll-over of loans to avoid a large-scale default. It's an obvious signal that local government debts problem has been big enough that certain measures need to be taken to keep things from getting worse.

Is local government insolvent?

If a local government becomes insolvent, we have to examine whether the problem comes from an unexpected decline in fiscal revenues or a sudden increase in expenditures. When it comes to local government revenue, the domestic and international macroeconomic environment matters a lot. If we take a look at brazil's experience of dealing with local debts problem, we could see it clearly that Latin American sovereign debt crisis triggered brazil's internal debts problem in the early 1980s and a jump in commodity prices contributed a lot to brazil tackling with the third debt crisis. Besides, the sustainability and diversity of a local economy are significant parameters in accessing local government's ability in generating cash inflows for future loan repayment. As for expenditures, we may look into whether a local government fully considers its affordability at the very beginning and borrow money in a reasonable and rational way.

In China's case, some people may show little concern about local government's insolvency for the growth rate of local fiscal revenue in 2011 given by the Ministry of Finance is as high as 29.1%. However, if comparing with the growth rate of local government debts every year, people may not be so optimistic about it. From 1997 till now, an average growth rate of over 30 percent of local debts and its huge base number would overwhelm the efforts in increasing revenues.

It is also doubtful whether local fiscal revenue would keep an relative high growth rate, since it shows a large fluctuation in recent years. In 2009, when Chinese economy reached its bottom in recent 10 years, the local government only increased their revenue by 13.7%. In 2012, with the painfully slow recovery of the US and the ongoing eurozone crisis, people predict a lower Chinese GDP growth in 2012 to be around 8.5%. We have to be prepared for a slower local fiscal revenue growth as well.

One point we need to make here is the sharp decrease in land lease revenue would get some local governments into trouble. In 2010, the land lease revenue is incredibly high which accounts for 72 percent of that year's local fiscal revenue. However, with central government's strict regulation and oversight of the real estate industry in 2011, the cold land market has directly influenced the local government's loan repayment schedule. In Guangzhou, municipal government even invited more than 200 real estate developers to the best restaurant to promote land lease trade.

Concerning the local government debts, there exist plenty of blind investments. In 2009, central government launched a four trillion economic stimulus plan which encouraged local governments to borrow money for all kinds of new projects. That's when the growth rate of local government debts reached its peak of 61.92%. Under a very loose policy environment, banks issued debts to many unqualified programs which can not generate enough incomes to pay off debts.

Combining all these factors, we could see that some local governments in China have a high risk of being insolvent. Investors really need to keep their eyes open.

A serious threat or not?

Will a local government debt problem expand to a debt crisis? In my opinion, the answer is no. According to the report, half of the debts are owned by eastern area which is far more developed and can better absorb those debts. Even if under some extreme events it turns into a systemic risk, the central government would not leave it alone. The implicit protection from Chinese central government who is sitting on huge foreign exchange reserves provides the last line of defense. However, this does not mean local government debt problem is not serious enough to be a threat to the national economy.

After one year's adjustment in fiscal and monetary policy, China now faces relative tight liquidity in the financial market. Because of the difficulties in getting loans from banks, many SMEs turn to private lending market for money. Once banks extend the maturities of loans, the remaining capacity for individual and enterprise debts would be further squeezed. SMEs as the backbones of Chinese economy would struggle to survive in a harder environment, and the transfer of economic structure from an investment-driven to a consumption-driven model is also under greater pressure. The concern about the default of local governments could probably put central government in dilemma in setting the priorities and making corresponding economic policies. What's more, the intervention of central government would break the market rules and induce moral risks. Local governments would take central government's aid for granted and become more bold to getting loans without scruple.

A prescription for local government debt

How does local government debts problem come from? We could ascribe part of the reason to the reform of Chinese fiscal system in 1994. After the reform, local governments need to hand in more and more fiscal revenue to the state treasury. For the perennial conflict existed between central and local governments, there's a metaphor saying that the central government wants the horse running while he has no intention to feed it at all. It's necessary for the central government to shift part of the fiscal power back to the local governments.

For local governments, they also call for the permission of issuing bonds to raise money directly. Instead of spending a lot of efforts in investigating and supervising the hidden and opaque companies used for local governments' financing, the central government would rather give rights to local governments to issue bonds. Compared with bank lending rate, the interest rate of bonds might be lower which reduces the financing cost. Besides, it could help local government think twice and cut down blind investment as the trade and price are decided by the market.

Up till now, local government debt is not a part of the budget management system, not mention the supervision under local people's congress. In brazil, they launched an overall reform in the field of fiscal policy, budget structure and financial system to solve the third debt crisis. The most outstanding achievement is Fiscal Responsibility Law which states clearly about the management of local debts. We also need to make relevant laws to confirm the legality of local government debts and then work out the detailed plans of how to strengthen the management and regulation of local debts.

We should feel glad that local government debt problem emerges before everything goes out of control. The central government still has time and chance to make things right and pull Chinese economy back to its right trajectory. We can hardly say local government debt has Chinese economy by the throat now, but it's more like a chronic disease. If you did not write a proper prescription for curing, then it might incur an irreversible damage to the Chinese economy someday in the future.

References: 
  1. Li, Ping.(2009). The management of local government debts, from an international comparison perspective. Beijing: China financial and economic publishing house.
  2. National Audit Office(2011). National audit results on local government debts. From the official website of National Audit Office of the People's Republic of China.