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

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Melissa Chua's picture

The Chinese economy has defied many naysayers’ expectations and escaped mostly unscathed from both the 1997 and 2008 financial crises. External forces as such have had no detrimental effect on the incredulous growth of the Chinese economy, yet Victor Shih brought to our attention a potential internal problem that could undermine the Chinese state. The Chinese Communist Party (CCP), since the opening up of its economy in 1978 has lost the right to call itself a communist country, now reinforces its legitimacy through the continued provision of astonishing economic growth to its people. It was suggested that the way in which the Chinese government has managed to maintain these seemingly logic-defying figures while maintaining low debt to Gross Domestic Product (GDP) ratio is through the “massive bank lending to local government” (Pei, 2011).

One starts to wonder how this potentially damaging problem could have escaped the notice of the Chinese population; after all there are strict central government restrictions on direct borrowing from local municipal government (“Chinese Local-Government Debt: Shell Game”, 2010). However in the land of state capitalism, many local investment companies (LICs) have been set up for the purpose of procuring loans from state banks on behalf of the local government (Roberts, 2010). Shih (2010) estimates that approximately 8000 of such companies (in early 2010) have taken advantage of the indistinct relationship between business and government to borrow excessively.

In June 2010, while the National Audit Office (NAO) revealed that “local governments have accumulated debts totaling 10.7 trillion renminbi (RMB)”, which makes up 27 percent of China’s GDP, the figures are tabulated based on a sample size of 6500 LICs (Pei, 2011). We can only assume that the number of LICs would more likely increase rather than decrease since early 2010. The central bank of China estimates that local government debt is 30 percent higher than that of NAO’s estimate (Pei, 2011). Hence with this incomplete information, Beijing can no longer be certain of magnitude of debts the local governments have gotten embroiled in. This lack of awareness could fatally hamper the Chinese state’s ability to deal with this growing problem head on.

Many issues linked to economic sustainability are raised. Doubts have been cast over the ability of local governments’ ability to service the debts and repay the loans they undertook. Pei (2010) mentioned two ways in which the government may do so: the first being through the sale of land used as “collateral for securing bank loans”, the second is by ensuring that loans undertaken were invested in economically viable projects that are able to generate profits. Considering the heavy debts borne by the local governments, taking up the first suggestion would mean having “to sell lots and lots of land every year for many years to come to pay interest payment on this debt” (Shih, 2010). This would snowball into another problem. The liberal sale of land would fuel the already problematic real estate bubble in China making the Chinese economy even more vulnerable when the growth of real estate prices eventually slows down or even reverses (Shih, 2010).

Pei’s next possible solution is a criticism made from hindsight bias. It is easy to say that in retrospect the Chinese government or the state banks should have ensured that the loans go towards the investment of sustainable projects. That aside, there is validity in Pei’s argument that at the end of the day these non-performing loans will reflect badly on the central government’s loose regulation pertaining to loans from the state banks. Associating that with the foundations of CCP’s legitimacy, the Chinese government will have a hard time explaining to China’s disenchanted population why economic growth has halted and their livelihood has been adversely affected.

At the same time, many believe that cash-rich Beijing has the ability to soak up losses to prevent widespread banking fallout. In fact the Chinese government has already begun its efforts to clean up local debt by shouldering some loans and making the state banks absorb some losses on the bad debt (Lim & Yao, 2011). “Part of the debt will also be shifted to newly created companies, while private investors would be welcomed in projects previously off-limits to them” (Lim & Yao, 2011). But all these accounting wizardry are but temporary measures that fails to address the real issue at hand – the liberal lending policies of state banks to LICs. The problems of transparency and accountability could potentially derail CCP’s political ambition.

However, we have to take into account that the piecemeal approach has always been characteristic of China. The Chinese government would have to consider the consequence of pulling the breaks all of a sudden on China’s lending to the local government, in particular the Western region. What may seem like a prudent financial decision may be construed as the central government turning its back on the less developed parts of the city. Especially in an area that is home to the population of “migrant workers, peasants, and restive minorities” most susceptible to political unrest and public discontent, the Chinese government can no longer solely rely on a hardliner stance to keep the unhappiness of the populace in check (Roberts, 2010).

In choosing the right course of action for the situation, the Chinese government has more than just economic considerations to think about. Having its political legitimacy built on economic prosperity is akin to playing with fire. China has so far in been able to ride the waves of external economic shocks, but as of now its primary concern should be balance the need for accountability on the part of its local governments with the promise of growth with equity. With that in mind, Beijing is taking baby steps beginning with a “lift (of) a ban on provincial and municipal governments selling bonds, a step aimed at bolstering their finances with more transparent sources of funding” while continuing its commitment to the Develop the West program for another 10 years (Lim & Yao, 2011; Roberts, 2010). The Chinese government should not have too big a problem tackling the local debts through its trademark gradual approach.


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