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

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Wei Jia's picture

A symbol of good fortune and power, the Oriental Dragon in Chinese Zodiac Signs may have disappointed investors on the first trading day after the Lunar New Year holiday. It is not about 2012 distress according to Maya Calendar, but does remind us of grim data on some issues that are as serious, if not more serious than, the world economic slowdown, the teetering real estate market and falling exports.

The climbing municipal government debt has been warned more than once home and abroad, but it is the scale of such huge borrowing that makes me gasp, for data disparity in the first place. In June 2011, the National Audit Office (NAO) released statistics about the government debt. It put the figure at RMB 10.7 trillion, 27% of China’s 2010 GDP1, while China’s central bank’s estimation was at RMB 14 trillion2, almost 30 percent higher than that of NAO. Those are not puzzling enough. Victor Shih, a professor from Northwestern University, suggested that local government debt at the end of 2010 could be close to 42% of GDP3.

The lending spree ensured from China’s stimulus program announced in 2008. Until 2008, local government financing platforms had taken up a small portion of loans. Since then, local government-backed financing vehicles/platforms borrowed heavily, making the debt ratio in some areas at more than 100 percent4. Certain local governments need to raise money for projects like roads, subways, schools, hospitals and “image projects” (e.g. city squares or stadiums). In my home town, for example, a Manhattan-like area is under construction. The problem is that projects alike hardly generate cash flow, thus endangering the local authorities’ ability to repay their debts. Worse still, the dropping prices in China’s real estate market only increase the likelihood of defaulting as a result of the falling revenue from land sales. Furthermore, the pile-up of debts and possible insolvency are feared to threaten the banking stability of the second biggest economy.

Is it a threat to the Chinese state? The picture may not be as murky as it seems.

In a country like China, which has not fully-integrated into the world’s economy yet, an assurance from top government leaders usually sets the tone of solving a serious issue. Historically, administrative directives and docile SOE giants have played the roles of pooling every effort aiming at the same goal. Apparently, recent examples include the borrowing binge resonated with the stimulus plan in 2008 and a number of financial vehicles created to enable local governments to circumvent the rules barring them from selling bonds. Similarly, the determination to resolve from the top signals a gesture that whoever tied the knot on the bell is the one to untie it5. History repeats. What we can do, however, is to be prepared for stakes and costs with an optimistic attitude of just believing.

In January 2012, China’s premier Wen Jiabao reasserted the public that the nation’s government debts are at an “overall safe and controllable” level and systemic risks would be avoided through stringent oversight standards. He also pledged to contain and defuse local government debt risks by clean-ups and regulation. Although the fraction that has been covered is buried in over RMB 10 trilliondebt as of the end of 2012, there are several facts that cannot be ignored when it comes to the debt/GDP ratio, the fiscal revenue and foreign reserves. First, China’s public debt/GDP ratio was at the low end of the range in comparison with other major economies at the end of 2009. According to the estimates by TrustedSources, the figure was at 55.5 percentof GDP. The global debt update in 2011 shows that the debt/GDP ratios for China, Brazil and India are 17.4%, 57.5% and 55.2%respectively. In addition, a noteworthy fact is that China’s public debt is mostly denominated in local currency. Second, in China, total government fiscal revenue has increased steadily over the past 10 years. A sustainable cash flow is very likely to follow even at the cost of requisitioning land from farmers. Third, China’s government debt is not dependent on external creditors to refinance its debt. When default was declared in Argentina in 20029, foreign investment fled, capital flow ceased and foreign reserves depleted. However, China’s foreign-exchange reserves reached USD 3.2 trillion in December 201110 so that the central government can easily refinance debt by issuing local-currency debt.

Admittedly, a brief combing through China’s preparedness tends to breed complacency about its status quo. If all the above facets are presumed to disappear in extreme conditions, the rosy picture of self-salvation may turn out to be a quick disillusion. A near-term state insolvency may be fended off as long as China’s economic fundamentals are sustainably strong. If default depends on the internal health rather than external environment or the legacy of an export-oriented boom driven by labor-intensive industries, China will need to strive for a long-standing guarantee, to which, there is no forthcoming answer. Since thirty years ago, this nation has embarked on a journey of crossing the river by feeling the stones. Enshrined in the 1982 constitution, the rule of law has been in the spotlight especially in recent years. In the river of development, legalism is the mainstream, partially because of the nudging effects of China’s membership into rule-based international organizations like the World Trade Organization. The question is where the next stone will be laid?

Given my observation, constitutional arrangements may avoid local governments’ illegitimate spending funded by tax payment, funnel more money to public projects, and foster the authorities’ awareness of living within means, thus nipping the improper debt financing in the bud. In my hometown, there is a copy of Manhattan under construction. The planned 164 million square feet of office space by 2020 is more than one-third of the 450 million square feet in Manhattan11. As the local financing vehicle, an infrastructure construction and investment company was established. The debt is rising, but the local authorities have to keep borrowing to generate cash flow for repaying. Beginning in 2008, residents in the locality were moved out of the area to make way for the project. Yet more borrowing is needed as the mayor said in September 2011, “if the banks don’t give us any new loans, there will be problems”12. Since the municipal government takes money from the public and spends it, a commonsense principle is that a taxpayer has the right to know the way tax revenue is spent, whether it is spent where he wants and to what extent projects for public use will benefit.

The breadth and depth of constitutional arrangements cannot be predicted, but the logical starting point is clear enough. A budget reform should be conducive to transforming understandings of citizenship and political representation, allocating government resources and improving the voting process so that voters can decide how the tax money will be spent in the authorized direction. Again, China can be likened to be someone who feels the stones when crossing a river. No one knows exactly in which direction he will finally go ashore, but a pragmatic probe in the mainstream saves him from drowning. The municipal government debt alert calls for another vital step in the megatrend13.