Is local government debt a serious threat to the Chinese state?

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iris yu's picture

China’s national audit office estimates that at the end of 2010, China's local government debt had reached 10.7 trillion yuan. According to some estimates, 20% of these local government debts will turn into bad loans. Many scholars and international organizations believe the local debt will threaten China's economy and the country's stability. But I think that the problem is under control and will be improved systematically because right now the size of the local debt is not a problem - the more significant issues are the response to the local debt, local public financial models and local government behavior. While we can't ignore the local debt problems, we do not need to over emphasize them.

The cause of the debt can be traced back to 2008, after the global financial crisis when the central government expanded credit, letting state-owned Banks support government infrastructure project. The move successfully boosted economic growth, but also led to an unprecedented amount of local government debt. Early of 2008, China’s debt balance scale was only 1.7 trillion yuan, but by the end of 2009, the rapid increase of local debt had made it to 5 trillion yuan - this can be explained by local government’s increased investment recover from the world financial crisis. But from the end of 2009 to the end of 2010, in only 1 year, the local debt balance doubled from 5 trillion yuan to 10.72 trillion yuan.On the one hand, this is the result of positive fiscal policy. On the other hand, the local government financing did not conform with policy.

Local debts have been increased also due to system and policy problems in China, such as high turnover of officials and the assessment of officials and achievements. Political achievements in China usually result in GDP growth or economic development a result of direct investment on government projects. In order to achieve the investment promotion and GDP growth goal, some local governments use the credit for guarantees. For example, by the end of 2001, the 65 projects which used foreign loans in Guizhou province have more than 70% reimbursement difficulties. Another important reason is the administrative expense: China accounts for the proportion of fiscal expenditure, which is 18.6% of GDP, the world's highest administrative cost. In addition, after the reform of the central financial and tax system, financial concentration significantly increased. At the same time, the provincial level also managed to increase financial concentration by collecting as much as possible from financial extraction capital and tax, which caused the difficulties in county and township governments.

Contrasted with the European and South-American countries, the history was similar in local government debt crisis. In the past, Argentina had two massive debt crises: the first in the late nineteenth century, the second in the 1980 s. These two crises brought huge trauma into economy of Argentina.

Argentina's economy was in trouble because of various factors: Mainly because the financial imbalances between the central government and the local government and the complex financial relationship in the 90 s which are closely related to financial reform. The central government’s financial power had narrowed, while local government financial rights had significantly improved. Fiscal expenditure has increased rapidly in the process: the central government didn’t take effective measures to supervise or constrain of the local government spending. So finally the greatly increased public spending caused about one-third of total government debt.

But in 1993 the outbreak of the debt problem in Brazil was far less than the later destructive Latin American crises. The Brazilian central government could calm finance system reform from system and structure to solve financial problems. At that time, the primary problem in Brazil was the internal debt. Local government debt problem was suspended in Brazil's economy, especially after 1997’s worldwide outbreak of a series of financial crises. But Brazil successfully controlled local government debt in both supply and demand. Demand control is to limit local government borrowing behavior and debt scale and supply control is to manage and monitor financial institutions in loan behavior.

Throughout Latin America and the Brazilian government debt problems, the government debt crisis is usually active after accumulating for a long time, and the local government generally expects the central government resolve the problem. The central government was generally unable to regulate local government behavior and was forced to give aid. These countries have similar government debt risk, which could be defined as a series of effects, such as government insolvency, default or bankruptcy. There are four major circumstances under which a government could become insolvent: Firstly, the asset bubbles bursting. These bursts cause recessions and give to a high-risk period of government debt risk of outbreaks; Secondly, recession causes atrophy in tax and government income; Thirdly, unavoidable fiscal expenditure is rigid, such as social institutional and financial infrastructure projects; Fourthly, the government financing atrophy is due to trust issues.

The present Chinese local government debt problems, compared with the crisis in other European and American countries, have many different aspects: one is the Chinese government ability to afford debt risk. Its debt level is far lower than international income and it has independent monetary system and strong government assets: a total of 35 trillion yuan of state-owned enterprise assets, and 80 trillion yuan of state-owned financial institutions assets, plus financial revenues are above 30% of GDP each year. Compared to the overall debt of the government, the government assets are stable no matter the scale and quality. Another aspect is that China's economic development is stable and positive. A good economic situation along with the economic structure and tax structure adjustment, the local government source will gradually diversify and local government debt risk problem will be slowly released.

However, there are certain negative effects of local government debt we cannot ignore.  Chinese economic development may be faced with a “lewis turning point” and a real estate bubble problem at the same time, with rising labor costs and agricultural prices which lead to inflation pressure and local government debt risk expansion. Although right now the influence of the local debt to China's macroeconomic is not obvious, the existence of the local debt that might be spreading further, would weaken the power of macroeconomic regulation and control policy. Because local governments can't go bankrupt, the debt risk would directly impact the government’s authority and social stability. Since China's economy has been growing for nearly a quarter of a century, considering aging and other demographic factors, the Chinese local government debt problem has to be mended in short-term and be solved in long-term.

In the short-term, China needs to eliminate the expectations of the Banks' bad loans and establish funds for the local financial crises. Although local debt in 1998 and 2008, which were two biggest increases, were directly related to financial crisis, local crisis saving funds can avoid the government to raise new debt, which must be larger than old debt to cover old debt. The most important thing is, China can't continue to reform the bank system by encouraging the expansion of credit .The credit scale expansion mode is the reason that banks are irresponsible to lend to the government platform, increasing the risk of local debt.

In the long term, China can solve the problem from two directions: policy and system. The system change mainly lies in the reform of the fiscal and taxation system which allows local government better control and use of local tax; The policy, only considering the GDP growth referring the macro economic growth, needs to be changed. Also China's economy heavily depends on exports and investment; improving household consumption in the proportion of GDP to change the phenomenon that China has always moved the family wealth to develop the prosperity of public sector investment, can stimulate economic development and transformation.

Another way is to expand the local government debt channel, from the market rather than from banks. Directly borrowing from financial markets by issuing bonds rather than financing through bank loans will be more restricted by market so there can be help in controlling the risk of local government debt. 

Nowadays, the Chinese government has decided to extend the term of local government debt to avoid default, and in the future, banks will decide the essence of the investment demand and consider whether the investment is for industrial upgrade and green growth following the 12th five year plan. This decision also gave government more time to solve local debt problems.

In my view, if the above short-term and long-term governance solutions can be carried out smoothly, China's local debt in coming years will be effectively controlled, crisis will be eased, and there would be less negative impact on the long-term development of the Chinese economy. In general, slowly growing and adjusting the economy, instead of lossing control in inflation and a hard landing of the economy, will most likely solve this local government debt problem.