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

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Jie Sheng's picture

When it comes to understanding the economic outlook, many would agree the mainland China stands outside the common sense of many economic principles. Such is the myth about local municipal debt, although analysts and economists often disagree dramatically on the numbers of total amount and even what should be count as local government debt, they seemto believe that given the high risk for real economy and investors, Chinese government is not likely to default. Although it might be no news for subnational government to become insolvent and legally go through the whole procedure under law, the concept in China is still far from a conceivable option, nor is it likely to become part of the law governing fiscal system in the country any time soon. The central government will always bail out the troubled local government and remind the market that the power of with its visible hand.

How big exactly is China’s local municipal debt? According to the auditors of central government, the number totals 10.7 trillion yuan, and about half of was formed during the 4 trillion yuan stimulus plan after 2008. This result was released in June 2010 after months of studying and had since become the official version, yet the calculations by agencies likeMoody and Bloomberg suggest much more should be expected by the market, the total couldbe around 14 trillion yuan or higher, depending on how much contingent implicit debt are counted as liabilities. However disputed the numbers are, the current situation seems at odds with the legal framework which states the local governments of China do not have the right to issue debt, nor is fiscal deficit allowed and the balancing of budget is due to be maintained with funding transfers from Beijing. Yet local governments had long been creative inacquiring funds in face of money shortage, from the infamous “land finance” to setting upinvestment companies that often in the name of urban construction—this explains why thepredictions over the risk of local municipal government debt had become such big issue: the fact that these off-book borrowing are unregulated, non-transparent and even unknown causesfear for systematic risk to the whole financing system. The number from official surveys hasonly limited credibility due to the governments’ murky record in transparency, and the amount of implicit debt exposed today could well be only a part of the iceberg. The state banks asmajor creditors may be able to take certain amount of nonperforming loans with the bailoutfrom central government, but this has to be based on the overall performance of growth, which points back to the argument of imbalanced economic structure and the danger of hard landing.

The “Chinese model” of economic growth has been characterized with heavy-handedness in government intervention, or “national capitalism” suggested by The Economist, and probably better known as “market economy with Chinese characteristics” within mainland China. However the growth driven by government spending and especially infrastructure investment would nonetheless led to the deficiency and distortion of market in many aspects. Take real estate market as the most prominent case: the local government has incentive to sell the land use rights for funding fiscal shortage and maintain GDP figure; capital in market with limited options of investment has incentive to go into real estate, among which are the often accused speculation behaviors that cause bubbles and skyrocketing housing prize in urban area—this has not yet taken into account the social effects as the suburban farmers are often poorly compensated compared with the price at which their land was later sold by government. After the central government decided to tighten land policy in 2011, many local municipal governments suddenly found themselves cut-off from the most important souse of income—among which are the most development municipalities such as Shanghai and Beijing, where land sale may count for nearly half of fiscal income. For central government the decision of “squeezing out real estate bubbles” cannot be an easy one, which is essentially weighing the risk of local municipal indebtedness, GDP growth and long-term economic health and stability.

If the most frightening feature of local government debt is because it is implicit and off the book, one logical option for central government is allowing local municipal issuing independent debt. The laws need to be changed accordingly to be sure, and the risks may become more manageable by bringing debt to light. Starting from 2011 several municipals a real ready been granted experimental status in issuing bonds, and the market reacted in rather welcoming way. The amount issued was rather minimal compared with total debt number, yet nonetheless showing the tendency of reforming to be carried out by Beijing. It is also internationally normal practice for sub national governments to issue own debts, but the big difference is in these countries the companying legal and regulatory institutions are also required in case of sub national insolvency, which would likely to be embraced in China anytime soon. Government insolvency is different from private bankrupt as the public service functions is still needed after default and hence the government is not likely to cease existing, nor could all its assets be liquidated. It is nonetheless necessary for such procedures to exist when deciding to issue bonds as central government have to make it clear its no bailout stand and force local governments to be responsible for itself. The debt crisis and following reforms in Brazil exemplifies this point, with federal government taken a rather hard line in regulating state borrowing, although sometimes economic efficiency is not fully addressed. In China’s case, as a unitary state, the local and municipal governments are traditionally and inherently under fiscal regulation of central government, and the reform process after 1994 has long been accused of strengthening central income at the cost of local fiscal capacity—a symptom described as incompatibility between incoming and spending capacities. While local governments still are responsible for most of the public goods such as education, health care social insurance, the tax sharing system provides no reliable income source. The majority of income transfer from central government is directed to certain programs and requiring local funding to match central fund as precondition. Most fundamentally, as the current fiscal system is essentially determined by policy regulations, constant bargaining between central and local government and competitions between local governments rather than set by law or supervised by the People’s Congress at according level (as suggested by the constitution), thelocal government has obvious incentive to pushing responsibilities of public service to the lower level of government and establishing investment vehicles to maximize funding from all possible sources, and leaving the current situation where the bottom level of government become heavily indebted and huge amount of infrastructure under construction waiting for funding. The argument goes that these constructions are long-term assets and would eventually serve economic development, yet the short term outcome of such somehow irrational investment rush is the pain of numerous local municipal government debt pains, the state banks_ bad loan woes and last but not least, the long forgotten loss of tax payers. The government could issue local bond to relief its heavy debt in short run, but without strong regulation and transparency rules, such process would only add to further risk and bubbles to economy.

Similar to the too-big-to-fail banks in global financial crisis, the severity of Chinese local debt is also starting to hold central policy decisions to hostage, for the state banks already started to ask the implicit debts of local government to be extended in due dates. Given the strong record of central intervention, Beijing is not likely to let the banks or local governments go insolvent. Such calculation also takes into account the high domestic saving rate, relatively stable market reaction and economic situation. However as the situation goes on, the central government have to use its heavy hand not only in controlling market but also pushing through reform and regulation in its fiscal system, and eventually political system for more accountability. The current distortion of market is ultimately based on the irrelevance of taxpayers and local supervising power, which should be contributing force to a more efficient fiscal system accompanied with effective regulation from central government and the legal system. The Chinese local government may not default, but the risks are not likely to go away easily.


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