Local government finances and debt—assessing the risks

The stimulus spending has raised concerns about local government finances. Local governments have ramped up infrastructure spending since late 2008, while they are also under pressure to spend more on health, education, and social security, for which they are in large part responsible. With monetary conditions likely to become tighter and land revenues possibly slowing down or even declining, local government finances may become strained.

At the heart of the concerns are local government investment platforms. These are state-owned enterprises (SOE)-type entities set up to finance infrastructure construction and urban development.[16] Set up in part to circumvent rules prohibiting local governments from borrowing, their investment activities are mainly financed by land sale revenue and bank financing, often using as collateral land requisitioned from local residents.

The amount of new lending to such platforms in 2009 has been very large, but this is not a new phenomenon. The CBRC recently estimated that their bank debt increased by 1.3 trillion yuan in 2009 to 5-6 trillion yuan at the end of 2009, with estimated additional committed lines of 3 trillion yuan. The possible total of 9 trillion yuan is equal to 27 percent of GDP, while some other estimates of the total liability are even higher. However, a large portion of this debt was accumulated before 2009 and so far no systemic problems have occurred as a result of it.

Problems would emerge if the infrastructure projects do not generate enough growth and revenues to pay the operating and interest costs and repay the loans. While the obligations are technically a liability of the platforms, they can become a liability of the local government in the case of an explicit or implicit guarantee from the local government or via subsidies to cover operating costs of projects that are otherwise not financially sustainable. To date, some local governments have at times gotten into financial problems. However, infrastructure construction in China has by and large created additional economic growth and the loans were repaid using higher future tax and land transaction revenues. Looking ahead, if things go well, this could continue to be the case. However, after the large increase in investment and debt in 2009, it is important to reduce the flow of new activity. In the medium term, the major risks lie in low(er) growth and volatile land sale revenues. New challenges are higher relocation fees for resettled people and the possibility that some of the second generation of infrastructure now being emphasized—sewage systems, environmental projects, public housing—may not boost economic growth and revenues as much as roads and ports have done in the past.

Such financial problems would affect future local government investment spending and could lead to a rise in non performing loans (NPLs). [17] Lower extra-budgetary revenues—because of policy tightening or a correction in the property sector—would mostly affect infrastructure construction and urban development. Localities that have relied heavily on land revenues and that have accumulated a lot of debt may face liquidity problems and could default on their debts, leading to non performing loans for the banks. While this is a problem for all banks, it is probably particularly a problem for smaller, local level banks and credit cooperatives. These are likely to have weaker risk management, may be more susceptible to political pressure, and tend to have fewer low risk loans in their portfolios. For the large, nation-wide banks, NPLs are likely to be less of a problem, as their portfolios tend to be better balanced and their lending to infrastructure has tended to go to larger projects with support from the central authorities.

The authorities are aware of the problems and have taken/announced measures to contain new local government lending and mitigate the risks. The People's Bank of China (PBC) and the CBRC have both warned of potential problems and called on banks to strengthen risk assessment of lending to local government projects. Some individual banks subsequently announced increased vigilance towards this type of lending. The Central Government is apparently considering issuing new rules on local government guarantees, with suggestions that letters of guarantee or comfort will not be valid anymore.

Given China's healthy growth prospects, with an appropriate policy response these problems are unlikely to be large enough to cause systemic fiscal or banking sector stress. The scale of the debt of the local government investment platforms and the possible problems created by it in the coming years will depend on economic growth and on the effectiveness of the government's measures to contain new local borrowing. If large portions of the debt end up being taken over by the government, that will add significantly to the official government debt. However, China's fiscal position appears to be sound enough to take that on, especially when compared to the fiscal position of most other major economies. Moreover, as a surplus country China has more room in deciding how to deal with such problems, since the government debt is largely held domestically.

However, reforms may be indispensable to mitigate such risks in the future. Overall, China's model for infrastructure financing has served the country well. However, reform of the intergovernmental fiscal system is needed to increase and diversify the revenue base of local governments, making it rely less on volatile land sale revenues. Moreover, local fiscal activity needs to become more transparent. It would be good to include land sale revenues and the infrastructure and urban development activity in local government budgets.

Key medium-term challenges and reform priorities

As the most acute phase of the global financial crisis recedes, and as China begins to prepare its new 12th Five-Year Plan (5YP), the focus of policy debates is also shifting from short-term stimulus back towards the medium-term structural reform agenda.

In the coming years, two key challenges stand out. The first is laying the basis for continued rapid development. In countries near China's level of per capita GDP, this is often termed the challenge of "avoiding the middle income trap". China's recent record of rapid GDP growth, and thus its ability to so far avoid this "trap", can be linked to successive bold efforts to reform and open up the economy, and to undertake needed public investments.[18] Continued success will require further impulses to create major new sustainable sources of demand and supply.

The second key challenge is sustaining recent progress in moving towards a "harmonious society". Much has already been done under the current 11th 5YP, which is heavily focused on meeting this challenge, but the agenda is far from complete. Specific challenges include creating conditions for more employment generation and for improvements in the "primary income distribution", in the quality of and access to public services, in expanded social security and other means to reduce vulnerability, and in efforts to create a less resource-intensive and more environmentally friendly form of growth.

Meeting these challenges will require a range of reforms and policy adjustments, most of which already featured prominently in the important speeches and policy documents presented to the recent session of the NPC. In many of these areas, some progress has already been made and policy plans and/or proposals are in the pipeline. Implementing them effectively will be the key to success. These reforms aim to achieve the following five inter-related objectives:

First, making further progress in "rebalancing" the economy. While China's past growth model registered many successes, senior leaders and economic analysts have long recognized its unbalanced and ultimately unsustainable nature. Speeding the shift from a model led by exports, investment and industry to one led more by domestic demand, consumption and services sectors, has become more critical than ever. This is for three main reasons. First, while China has made strong progress in achieving many objectives of its 11th 5YP, more limited progress has been made in rebalancing growth. This has in turn limited progress on other key objectives of the 5YP. Second, with subdued near- and medium-term prospects for the post-crisis global economy—and thus for export demand—China will need to generate more domestic demand if it is to sustain relatively fast GDP growth. Third, issues of social and environmental sustainability are now prominent in the reform agenda, with rebalancing also being key to progress in these areas. Rebalancing would support growth by creating new, permanent sources of domestic demand, including more consumption, more health and education spending, and new investment opportunities in growing sectors (notably services) and booming localities (e.g. inland provinces, cities). A rebalanced economy would be more labor-intensive and thus support the "harmonious society" agenda by creating more jobs for a given level of growth. This could in turn create the basis for improvements in the primary income distribution. Such changes require a range of policy adjustments to address distortions which have worked to overstimulate exporting, investment and industrial output and to overly discourage domestic demand, consumption or the services sectors.

Second, enhancing efficiency gains in all sectors and spheres of activity. While recent growth of total factor productivity (TFP) has by no means been low, the main driver of China's GDP growth has been physical capital accumulation. However, if rapid growth is to be maintained, TFP will have to play an increased role. China's investment rate is already very high, making further increases unlikely and/or undesirable. The shrinking demographic dividend will work to further cut the contribution of labor. Greater efficiency can be supported in many ways. Reforms to the pricing of capital, energy, and other natural resources will lead to more efficient use of resources. Financial sector reform can improve the efficiency of capital, as can SOE dividend policy (Box 1). Further policies to support innovation can help China's export enterprises move up the value chain. Opening several "monopoly" sub-sectors in services and public utilities to competition and private sector participation can produce large efficiency gains not unlike those achieved by similar policies in the manufacturing sector a decade ago. Further rural reforms, especially in implementing recent policy reforms on land use rights, can lead to a more productive agricultural sector. An enhanced focus on human capital creation (health and education) will lead to a more productive workforce.

Third, pursuing a more sustainable spatial transformation of economic activity and employment. While the core of this agenda is about moving to a more permanent and successful form of urbanization, it also includes the shift of economic activities, e.g. from coastal towards inland areas. Further urbanization is inevitable as China continues to develop. It can also be a positive source of sustained consumption growth, and creating demand for major new investments in productive activities, infrastructure, and housing. The resulting agglomeration effects can further raise productivity, especially if backed by investments to connect urban centers. However, urbanization needs to be pursued with due attention to social and environmental sustainability. Movements of people create challenges for public service providers in both locations losing and gaining population (health, education, social services, local utilities and infrastructure). But the benefits of more urbanization and mobility are so large that it is important to overcome these challenges. The recent measures to improve the portability of pension rights are very welcome in this regard (Box 2). Urbanization can further be spurred and made more effective by complementary reform of land markets, urban planning, and the household registration (hukou) system. It also needs to be balanced by a substantial transformation of the rural economy. Absolutely central for progress on this agenda is the reform of local government financing and inter-governmental fiscal relations.

Fourth, further changing role of the state in the economy. This role has evolved significantly over the past 30 years, and should continue to do so. In some sectors, this will entail expanding the role of the market, with the state shifting from the use of direct controls or dominant ownership stakes towards a greater focus on incentives, appropriate regulation, and other indirect means of governance. Such areas include the financial sector, the broader services sectors, some of the to date more restricted utilities sectors, and land use rights. Conversely, in some other areas, the direct role of the state could be enhanced. These include the provision of health and education services and various dimensions of reducing vulnerability, including pensions, social assistance and climate change adaption.