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

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CHAK HING CHAN's picture

Is Local Government Debt a Serious Threat to the Chinese StateOn 27th June, 2011, National Audit Office of the People’s Republic of China released “Audit Findings on China’s Local Governmental Debts”, which focused on the debts payable by the local governments. This report shows that, as of the end of 2010, the debts of Chinese local governments stood at 10.7 trillion RMB, which was equal to 2.7% of the GDP in the same year. Many economists consider that this situation has already become a time bomb to China and it is impossible for Chinese local governments to repay all the debts on time. They are certain that China will face economic downturn and go bankrupt.

The huge amount of debts in local municipal governments is no doubt un favorable to the development of China, but only in short term. The debt crisis is more likely to be a catalyst for the improvement of administrative efficiency of local governments and financial health of private firms, which further enhances the economic and social growth of China in long term.

To begin with, the growth of debt size is on the downturn. From the Audit Findings, as of the end of 2010, 51.15% of the debts was incurred in or before 2008. This means that another half was incurred in 2009 and 2010. These two years can be regarded as “exceptional years” since the Chinese central government implemented stimulus policy to boost Chinese investment to maintain strong economic growth during global recession. With the end of this expansion policy in 2011, it is expected that the increase of the debt will slow down rapidly in coming years. In2010, the growth of debt was 18.86%, dropped by 43.06% compared to 2009. In near future, the debt size will no longer have such stunning growth like in 2009 and 2010.

Moreover, the debts create assets to local governments. Debt itself is not purely a capital outflow but leverage for investment on different areas. According to the Audit Findings, more than two-thirds of the debt was used in municipal infrastructure construction, transportation development and water-conservation projects. In other words, a large portion of the debt actually creates valuable assets with direct long term returns, and indirect economic and social benefits. Local governments can repay its debt and corresponding interest by both direct and indirect returns, and even by selling the assets.

On the other hand, the central government acts as the last resort to repay the debt. Most of the local governments are not able to repay all the debts and interests on time by their own income. In 2010, the total income of local governments was about 7.3 trillion RMB, including 2.7 trillion RMB which came from land transfers. Due to the falling real estate price level and land swaps, it is certain that local governments will no longer have huge income from land transfers in near future. The remaining 4.6 trillion RMB can be regarded as the baseline of the total local government income in coming years. From the Audit Findings, local governments have to repay1.8 trillion RMB, 1.2 trillion RMB and 1 trillion RMB in 2012, 2013 and 2014 respectively. In order to maintain basic expenditure on education, public health, public housing, etc, it is difficult for local governments to slash expense for repayment of debts. The central government will have to pay part of the debts to avoid default.

With diminishing debt growth, potential return from assets and monetary support from the central government, the local municipal government debt crisis is definitely not a disaster to the China. However, the debt still brings adverse effect to China’s economy. It is anticipated that China will implement strict financial policies to avoid another large scale debt crisis. First of all, local governments have to cut unnecessary expense and loans upon request from the central government. Reducing complexity of local government structure is one of the ways to cut expenditure. China is the only country that practices 5-level government system (central, provincial, prefectural, county and township levels) among the world. The functions of some local level (all levels except central level) departments are duplicated and this leads to unclear responsibility between departments. Simplifying the government structure does not just reduce the complexity and cost, but also increases the efficiency of government administration. However, aiming at reducing loans, local governments become reluctant to have large scale investment like municipal infrastructure construction and development.

Furthermore, borrowing of local governments requires consent from the central finance department. Local governments cannot borrow capital without authority. The source of borrowing is limited to Chinese banks and governments from higher levels. The borrowing details, such as size, duration, interest, targeted investment or projects, etc, have to be reported to the central government. The authorized units can do lending to local governments only with the central government’s acceptance. The increased difficulty of borrowing forces local governments to carefully plan their investment projects. This lowers the opportunity to run unprofitable projects and the amount of bad debts.

Apart from the control on local governments, the central government also has to advice the banks not to make loans to any unprofitable investment. According to the Audit Findings, bank loans constituted 8.47 trillion RMB, or 79% of the debt. To avoid collapse of Chinese banking system, what the central government can do is to repay the local municipal government debts. Banks have to be more careful on making loans to local governments and private sector to prevent another bad debt crisis. With higher difficulty on making loans, cost of making loans rises and private firms face liquidity problem. Those weak firms which cannot tackle the liquidity problem will go bankrupt and their assets will be absorbed by other strong firms. The firms with low management ability and production quality soon disappear.

Similar to contraction policy, both controls on local governments and banks reduce loan volume. Local governments and private sector are less willing to have large scale investment and production projects. Unemployment rate rises and GDP growth drops in short term. This is a painful process to China and Chinese citizens. However, in long term, the improved local municipal governments and strong private firms can contribute much more to the China’s economy and society.

To sum up, the local municipal government debts only bring minor problems to the China. The adverse effect of debt repayment pulls China into a painful process with decreasing GDP growth and employment rate in short term. After all, the enhanced government efficiency and private firms’ management allow China to have a much healthier economic system and higher economic growth.