Is Local Government Debt A Serious Threat To The Chinese State?

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Yun Bai's picture

I. Introduction

The topic of China’s local government debt has been consistently debated since European sovereign debt crisis surfaced in 2009. China’s local government debt problem is the result of the mismatch between local government spending responsibilities and their revenues. After the Tax Sharing Reform in 1994, China’s central government gained most tax revenues, leaving many local governments with soft abilities to fund local infrastructure projects. Moreover, in 2009 Beijing carried out a RMB 4 trillion stimulus package, of which over 2.8 trillion were to be matched by local governments.1 Because the China’s Budgeting Law prohibits local governments from issuing municipal bonds, the local governments have to raise funding through government-controlled companies called Local Government Financing Platforms (LGFPs). The local governments provide LGFPs with collaterals such as land and state-owned utilities companies, and the LGFPs in turn use these collaterals to get enormous amount of bank loans to fund government projects. According to China Banking Regulatory Committee, by June 2009, the number of LGFPs has exceeded 8000.

On June 27, 2011, China’s National Audit Office (NAO) released a comprehensive report on local government debt, estimating that the local government debt in China totaled RMB 10.7 trillion, of which 8.5 trillion are funded by bank loans.2 It is worth pointing out that NAO’s report merely gives one estimation of China’s local government debt situation. Moody’s Investor Service, for example, claims that the NAO report is understating the size of the local government loan by as much as RMB 3.5 trillion. In addition, according to Moody’s, the non-performing loans (NPL) could reach between 8% to 12% of total loan amount.3

In my opinion, the local government debt is a serious threat to the Chinese state in several ways. In this paper I will examine the threats that local government debts have on the Chinese state, and propose several solutions based on the successful experiences from other economies.

II. Local Government Debt Threatening the Chinese State

The direct impact of the large local government debts is that local governments are forced to increase their revenue in order to meet their debt obligations. There are two main sources of local government’s income: tax and land sales. An increase in tax rate will hamper the development of a local economy by prohibiting local economic activities, and will cause unemployment rate to go up. In the long run, local tax base will shrink and this method can only have limited effect on increasing local government revenue. On the other hand, an increased in land sales price will further push up real estate prices and cause anxieties among people without home ownership. Both of these methods to increase local government revenue are unsustainable and, if not managed properly, can cause social uncertainty and even civil unrest. Even till today, the central authorities of China have not shown any sense of urgency in the local government debt problem. Beijing has repeatedly claimed that they are not worried about the quality of local government debt. However, since most of the assets of LGFVs are illiquid, and the cash return on public projects such as highways and utilities are very low, local governments rely heavily on issuing new debt to pay back old loans and interests.

Therefore the ability of local governments to meet their debt obligations is highly questionable. Because the majority of local government debts are owed to banks, if a local government is unable to meet its debt obligations as they come due, there are two cases that can happen: (1) local governments will default and banks will take losses or (2) central government will step in and bail out the local government. In case (1), the local government’s credit rating will be hurt, and the cost of future borrowing will increase. This can significantly affect the future development of a local economy. In addition, because a substantial amount of local government debt is funded by loans from large state-owned banks, these banks can run into a liquidity crisis if too many local governments default. Banks will increase borrowing standard, and slow down the growth of China’s economy, as happened in the United States after the recent economic downturn. In case (2), given the financial strength of China’s central government, bailing out a few local governments will not be a problem at all.

However, the real problem is that local government bankruptcy can trigger a “bankruptcy domino”. If one local government can default and get financial assistance from the central government, so can the others. By then, the central government will not only need to cut crucial spending on projects like education and healthcare to pay back debts for local governments, but also need to print money to pay back debts and cause substantial inflation. If that happens, China’s credit rating will be affected, RMB will depreciate, and a dollar-linked debt crisis can explode. Because in China both the major banks and local governments are owned and controlled directly by the central government, it is essentially the same whether case (1) or case (2) happens; the central government will have to come in and solve the problem, either by helping local governments to pay back their debts, or by helping banks to absorb the bad debts, or both. The burden of repaying the local government debts will eventually be on Chinese taxpayers, and it is important to properly handle the conflict between taxpayers and local governments.

III. Possible Resolutions

To tackle the local government debt problem, the first step is to increase transparency of local government debt situation. Currently, because most of the local government debts are borrowed under LGFPs, it is hard for the public to supervise the debt situation and warn against potential risks. Local governments should include the debt obligations under LGFPs in their budget and publish detailed reports every year. Governments should also include debt management result into the performance evaluation for government officials. This way the government officials’ interest will be aligned with solving the local government debt problem, and excess borrowing for unnecessary projects will be controlled.

In the short-run, the central bank, People’s Bank of China, can help the commercial banks by partially buying at discount their bad debts from local government debts. The People’s Bank of China will also need to provide short-term liquidity to the banks to let local government to refinance their maturing debts, which are over 2.6 trillion in 2011 and 1.84 trillion in 2012. According to Razin and Sadka, credit ratings have a self-fulfilling effect. In the process of solving local government debt problem, if China’s credit rating is affected, the central government will have to cut their spending rather than increasing current tax rate to raise the primary surplus in order to avoid a “Brazilian-type debt crisis”.4

The central government can slowly open up the privilege to issue municipal bonds for selected local governments, and if successful, to other local governments as well. Recently, Shanghai has already become the first city in China to issue municipal bond. This will be an important step to ease the local government debt problem. Local governments in relatively developed areas can consider introduce private funding into LGFPs to let strategic investors to take part in infrastructure projects. If properly directed and managed, this move can not only lower the debt ratio for local governments, but also increase management efficiencies for the projects that are traditionally run by local governments.

Most importantly, the central government should come up with a long-term debt management and supervision mechanism for local governments. For example, in Colombia, the government uses a “traffic light” system to monitor the risk of local government debts. If a local government’s interest payment is less than 40% of its revenue, and debt ratio is less than 80%, then it is in “green light district” and allowed to borrow from banks. Otherwise it will be in “red light district” and borrowing is prohibited. In Brazil, it is regulated that the outstanding balance for local government debts cannot be higher than 45% of a bank’s total asset. 5 Similar standards can be set for local governments in China to make sure that local governments do not borrow beyond their capacity.

The central government should also allow localities some formal revenue-raising autonomy. Property tax, which is being tested in several cities at this moment, is a sustainable example for raising local government revenue in the long run. The central government can also take on more spending responsibilities on major projects. Matching the spending responsibilities and revenues of local governments is the only way to make sure that the local government debt problem do not happen again in the future.

References: 

1. Razin, Assaf, and Efraim Sadka. "A Brazilian-Type Debt Crisis." IMF Staff Papers 51 (2004): 148-53. Print.

2. National Audit Office. "2011 年第35 号:全国地方政府性债务审计结果." Web. 18 Feb. 2012. http://www.audit.gov.cn/n1992130/n1992150/n1992500/2752208.html

3. Xu, Antuo, “Risks of Local Financing Platform: Total Controllable but Some Areas Are Serious.” Journal of Central University of Finance and Economics 10(2010). Print.

4. Zhang, Yi, Jean-Francois Tremblay, and Stephen Long. Growing Size of Local Government

5. Debt Burden Challenges Chinese Banks. Rep. Moody's Investor Service, 2011. Print.

6. Liao, Qiang. For China's Banks, A Little Pain Now May Prevent A Lot Of Pain Later. Tech. Standard & Poor's, 2011. Print.

7. Green, Stephen. China - Solving the Local Government Debt Problem. Rep. Standard Chartered, 2011. Print.

8. Xu, Antuo, Risks of Local Financing Platform: Total Controllable but Some Areas Are Serious

9. National Audit Office of the People’s Republic of China, http://www.audit.gov.cn/n1992130/n1992150/n1992500/2752208.html

10. Moody’s Investors Service, Growing Size of Local Government Debt Burden Challenges Chinese Banks. July 4, 2011

11. Razin, Assaf and Sadka, Efraim, A Brazilian-Type Debt Crisis: Simple Analaytics. IMF Staff Papers, Vol. 51 No. 1 (2004), pp. 148-153

12. Hu, Lijian, An analysis on experience and revelation of local government debt management in foreign countries