MANAGING LOCAL GOVERNMENT DEBTS IN CHINA

The recent decision by Moody's to downgrade China's credit rating outlook from stable to negative has sent ripples through global financial markets, shining a spotlight on the structural challenges looming over the world's second-largest economy. At the heart of these concerns lies China's staggering local government Debt (LGD), a ticking time bomb that threatens to undermine economic stability and growth prospects. According to various reports on varying debt figures, Reuters claimed that the total LGD of China has reached 92 trillion Yuan ($12.58 trillion) or 76 percent of the country’s economic output as compared to China’s external debt of $2.38 trillion in 2023, casting a shadow over the nation's fiscal deficit target. Even more alarming is the assessment by economists at Goldman Sachs Group Inc., who warn that a slowdown in property demand and real estate crisis could further exacerbate the pressure on local governments. With growing debts and economic staggering, the clash between local government and Central government is obvious, as it is one of the outcomes of fiscal recentralisation by the Chinese Communist Party in the past and manifested through different events. This opinion piece delves into the complexities surrounding LGD and explores the implications for the country's economic future and current state of debt management.

Source of local debts

Following China’s 1994 tax-sharing reform, and in the wake of the 2008 global financial crisis, the central government initiated an expansive fiscal stimulus program aimed at revitalising the economy. However, as part of the decentralisation process and the practical challenges associated with transferring fiscal power, local governments found themselves under pressure to shoulder increased responsibilities. In response, provinces turned to heightened infrastructure investment through Local State Banks and Local Government Financing Vehicles (LGFVs). Funded largely through additional borrowings - in anticipation of stimulating demand in the economy through the infrastructure development over a period of time- but sluggish demand and economic slowdown foiled it into a high debt burden on local Governments.

Furthermore, the central government's predominant emphasis on metrics like GDP as the principal yardstick for evaluating the growth and development of local governance within the official assessment framework, combined with a vertically re-centralized fiscal reform structure, has incentivized local authorities to pursue expansion fuelled by debt. This strategy has not only led to a swift escalation of debt at the local level but has also compounded the debt accumulation predicament, thus laying the groundwork for the challenges confronting China today. Consequently, these challenges are evident in the ongoing economic deceleration and the real estate crisis gripping the Chinese economy.

A clash between centre and provinces

The dynamics of fiscal reforms between China's central government and local authorities have long been a balancing act. In the mid-1990s, Zhu Rongji made a significant shift, granting the central government a greater share of tax revenue while delegating non-tax revenue and fiscal tools to provinces, aiming to spur local economic growth and alleviate central government burdens in development initiatives. However, this restructuring created a substantial fiscal gap, bridged by issuing high-interest municipal bonds with short maturity periods. Despite such financial maneuvering, the aftermath of the global financial crisis prompted local governments to inject stimulus via hefty infrastructure investments, exacerbating off-balance-sheet problems as companies borrowed on behalf of provinces and LGFVs borrowed against mortgage lands, strained both companies and local state-led banks. The resultant unsustainable local government debt sparked friction between the two levels of government and raised questions on the fiscal autonomy of provinces.

Meanwhile, the national growth strategy, fixated on bolstering GDP, relied heavily on infrastructure development facilitated through LGFVs purchasing or selling property entrusted by local governments for funds. However, this approach burdened local administrations, especially amidst the property market crisis. The repercussions were evident as regions witnessed the precarious situation of LGFVs teetering on the edge of default. The recent real estate sector downturn, compounded by the struggles of industry giants like Evergrande and Country Garden, has heightened fiscal fragility, directly impacting the national economy and stoking tensions between provinces and the central government.

Impact on the National Economy

Economists frequently emphasize the adverse effects of government-driven economic expansion, despite China's considerable economic stature. Some even argue that the true scale of LGD remains obscured, casting doubt on the nation's controlled economic development model. This view is widely held, with experts asserting that local debt is not only widespread but also severe, significantly impacting the national economy. Evidence from sources such as investigations by Bloomberg and the Financial Times, highlights alarming levels of borrowing and their consequential effects. Furthermore, studies consistently demonstrate an inverse relationship between debt accumulation and economic growth. When other growth determinants are controlled for, a ten-percent rise in the debt-to-GDP ratio corresponds to a significant deceleration in annual per capita GDP growth, by approximately 0.23 percent annually. Consequently, the burgeoning local government debt poses not only a challenge for local authorities but also hampers China's overall economic trajectory.

Challenges and the way forward for local debt management

In the midst of a burgeoning local government debt crisis and sustained real estate downturn, the Chinese government faces a critical moment, striving to avert potential black swan events and prevent a crash. Initially, local governments issued municipal bonds in 2013 with shorter maturity periods to curb the growing LGD. However, amidst an economic slowdown and a crash in real estate demand, local governments struggled to repay accumulated debt, leading to subsequent issuance of bonds with longer maturities. The economic slowdown, compounded by the downfall of major real estate developers like Evergrande, renders the management of LGD unsustainable. Moreover, the allocation of non-tax revenue rights to provinces fails to bridge the fiscal gap created by the 1994 fiscal reform. Proposals to impose property taxes on the middle and upper class to counter this shortfall face resistance. Meanwhile, local governmental entities and financial institutions, entrusted with driving growth, confront risks stemming from prolonged infrastructure investments, dwindling land transaction revenue, and increased pandemic-related expenses. The issuance of additional debt instruments by local governments further strains their financial sustainability, necessitating comprehensive fiscal restructuring to mitigate escalating indebtedness and safeguard China's economic framework.