Since the 2008 financial crisis, the Chinese municipal governments have encouraged massive initiation of infrastructure projects. Some of the project-related loans have faced potential default risks due to various causes such as incompletion and opaque funding procedures.
According to recent news1, China’s local government debt is estimated at $1.7 trillion, which is roughly 23% of the country’s 2011 GDP figure converted with current RMB/USD exchange rate. The sheer size of the debt could fuel concerns about the fiscal sustainability of the local governments.
In spite of such uncertainties associated with the government loans, it could be beneficial to get a broader view of the picture, considering China’s robust economic growth during the crisis. This article is going to present some empirical evidence related to this question from a broader perspective.
When we consider a government’s fiscal sustainability, the following model could give us an intuitive understanding of the possibility of a default.
A default is possible in period t if the government faces a positive fiscal shortfall (SFt),which is the difference between interest and maturing debt payments due in period t (Dt)and the amount of disposable cash (Ct). The government’s disposable cash is assumed tobe positively related to economic output in period t (Yt).
The financing cost (r) faced by the government at this stage is associated with the amount borrowing (Bt) and other relevant conditions. Despite current fiscal shortfall, excess financing can still be used to stimulate the economy. Thus, expected next-period output is related to excess borrowing and is conditional on pre-stimulus output (Yt+1 ).
Consequently, the government’s financing decision in the current period will affect the expected next-period fiscal shortfall in the following ways (Dt+1 is the next-period interest and maturing debt payment if current period financing is zero).
The government in financial distress should prudently choose an optimal financing strategy in order to minimize expected fiscal shortfall. The financing decision will depend on whether fiscal stimulus can generate a positive net fiscal cash flow for the government. This is shown by the following first-order partial derivative equation.
If additional investment in the economy is expected to generate fiscal income which is higher than the cost of financing, the government will have greater incentive to provide stimulus by borrowing more than current fiscal shortfall and avoiding default in the current period. The financial markets will also be expected to respond positively to the stimulus measures. Consequently, the cost of financing could possible decrease, further reducing the default risk.
Contrarily, if stimulus is not expect to improve future fiscal conditions, the government will face a trade-off between default and refinancing. The latter avoids default in the current period at the expense of higher next-period fiscal shortfall, as shown in the equation below.
In summary, the probability of default is deeply related to the efficiency of the economy. An increase in the value-created with additional input in the economy leads to a decrease in the probability of government default, given current fiscal shortfall. Therefore, the economic sustainability is fundamental to the fiscal sustainability of a government.
Focusing on China
Based on the previous analyses, the efficiency of value creation in the Chinese economy is an essential issue to the government debt problem. Inspired by the Cobb-Douglas Production Function as well as Autoregressive time series models, I have constructed the following model which utilizes components in both models.
In order to capture the interrelated causality relationships between output (Y), Labor (L),Capital (K) factors and their lagged observations, I have selected the Vector Autoregressive Model (VAR) to fit the logs of nominal GDP, total workers’ wages and capital formation time series2.
Preliminary analyses utilizing the autocorrelation plots above as well as information criteria (AIC and BIC) suggest the following second-order VAR(2) model.
Yt, Lt and Kt are respectively logs of aggregate output, labor and capital. Ø1 and Ø2 are 3by 3 coefficient matrices. δs are constant terms and Et is a vector of errors. The following equation is extracted from the VAR regression.
By taking the derivatives of the time series, we can find the following relationship between the factors and output growth rates (g).
This equation gives us a forecasting relationship between additional factor inputs and the increase in next-period output growth conditional on current economic growth rate. Assuming that a fiscal stimulus package which is released at t does not change the composition of the economy at least in the short run, the total nominal amount (x) will translate into equal percentage increase in the factor inputs. The expected increase in output growth at t+1 and t+2 will be the following.
a1 + ß1 and a2 + ß2 are respectively one- and two-step ahead growth multiples, which represent the expected percentage output increase in t+1 and t+2 after a 1% increase in both L and K factors at time t. The following plots are growth multiples estimated by rolling VAR regressions. Each coefficient is estimated with observations in the previous decade.
As an intuitive indication, Figure 2 suggests that China’s recent economic growth has demonstrated improvements in efficiency. Relating to the model in the previous part, it is possible that additional fiscal stimulus could generate positive cash flows for the local governments in China. Apart from refinancing the infrastructure project-related loans, on-going reforms of municipal government financing could reduce default risks by providing more transparency. Thus, China’s municipal governments may still maintain fiscal sustainability even though the amount of outstanding local government debt has increased since the financial crisis.
Conclusion and Discussion
Fiscal sustainability and sustainable economic growth are fundamentally related. By comparing China’s situation with that of the deeply troubled European countries, we will realize a big difference. The structural transition of the Chinese economy is bringing about many potential development opportunities in various sectors. The growth potential not only eliminates the government’s incentive to default (which will jeopardize the development opportunities), but also reminds investors that the risks are manageable.
The case of municipal government debt, in particular, is a matter of short-run uncertainty rather than fundamental inefficiency. The following measures could help solve this problem.
· Further push the reform of the municipal government financing platform in order to improve transparency
· Diversify stimulus measures by investing in a broader range of projects (such as clean tech and new energy) in order to reduce the aggregate risks
· Encourage entrepreneurship and civil capital participation in those public sector projects in order to provide multiple supervision and better due diligence
- China allows one-time rollover of local government debt-paper, retrieved on February 19th 2012 from Reuters: http://www.reuters.com/article/2012/02/16/china-banks-debt-idUSL4E8DG0D5...
- GDP, total workers’ wages, capital formation time series, retrieved on February 17th 2012 from National Bureau of Statistics of China website: www.stats.gov.cn
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