This briefing is the first in a series of two that aims to introduce the non-specialist reader to Chinese local government debt. This briefing aims to shed light on why local governments in China borrow and why it is a problem and the second briefing will discuss the reform wave that began in 2013. Before proceeding, then local governments are here defined as the lower four of five levels in the Chinese political administrative structure: central, province, prefecture, county, township (source).
1. Why do we care about local governments in China in general?
One major reason that local Chinese governments are interesting is that most fiscal responsibility is held by local governments in China. More specifically, in 2015, 86% of government expenditure occurred at the sub-national level, while the sub-national government received only 54% of total government revenue (source). Two points arise when looking at these numbers. Firstly, China is much more decentralized in terms of both revenue and expenditure than all other major economies. In OECD countries, the average subnational share of revenue was 65% in 2015, whereas the share of expenditure was 31% (source). Secondly, the gap between subnational revenue and expenditure is larger in China than in other large economies. Whereas the 2015 local government fiscal deficit was 32% of GDP for China, then the average OECD country had a local government fiscal surplus of 34% of GDP. The below figure provides a more detailed overview of revenue and expenditure at different government levels in China.
Diagram 1: China is fiscally decentralized (2015 data) (source)
2. Why do Chinese local governments need to borrow?
The previous section gave a hint as to why local governments in China borrow: they have to spend more than they “earn”. Yet the revenue-expenditure gap is not the whole story. While there are likely many reasons for the increase in local government debt, the 1994 fiscal reform and post-2008 fiscal stimulus are two main causes. Examples of other frequently mentioned reasons include 1) that the central government implicitly guarantees local debt, leading to moral hazard among local governments, 2) that economic growth is emphasized in the evaluation of local politicians, leading to debt-fueled growth, and 3) that local officials can influence banks, allowing local governments to access financing on non-market terms. This briefing argues that these three factors, while important enabling contextual factors, are not root causes as they have existed for decades in China.
2.1. Long term: 1994 fiscal reform
The massive fiscal deficit faced by local governments in China can be traced directly to fiscal reforms implemented in 1994. While China experienced real economic growth that averaged around 10% per year between 1979 and 1993, government revenue as a share of GDP fell from 28% to 12% during the period (source). The fall in government revenues led the government to implement major fiscal reforms in 1994, something that enabled the central government in Beijing to increase its share of total government revenue from 22% to 56% during 1993-1994 and nearly double the ratio of government revenue to GDP in the following 20 years (source). The 1994 reforms achieved its goal of fiscal centralization, although local governments until today face “expenditure responsibilities [that] exceed their assigned revenues” (source), why the local governments have had to find ways to fill their revenue gaps. Local governments have plugged their funding gap by borrowing from banks and shadow banks, and selling land (often by expropriating land from citizens and compensating them at below-market rates).
Diagram 2: impact of the 1994 fiscal reform (source)
2.2. Medium term: post-2008 stimulus
During 2008-2010 the Chinese government decided to implement major fiscal stimulus programs worth almost $600 billion (source) to counteract the financial crisis, with around three-fourths of the money going to local governments. While this initially might sound positive for local governments, despite “the significant outlays, the money the center [gave was] nowhere near enough to fund all the local projects” that it approved (source). Despite the stimulus package resulting in local governments taking on more debt through a range of direct and indirect channels, then most of the money was spent on infrastructure and other public goods – projects on which “the income-earning potential of the projects is limited” (source). According to one estimate, local government debt increased by around 60% in 2009 (source).
3. Why is local government debt a problem in China?
Although the aggregate national debt burden is not a cause for huge concern at the current debt levels (source), then this briefing argues that the rapid increase, geographical variation, reliance on land sales and opacity of debt are concerning.
Increase in size
The increase in size of local debt, and the ability of local governments to cover such debt is a rather straight-forward story: the debt burden has increased significantly as both a share of GDP and as a share of local government revenue, however measured.
Diagram 3 and 4: increase in size of debt (source)
The national average of local debt, however, covers a broad range of provincial debt levels, as seen in diagram 5 below. The broad variation in debt burden could easily resemble the variation in debt across a sample of countries, making this author ponder whether a potential local debt crisis in China might be idiosyncratic or systematic across only a subset of provinces, particularly given clustering in the economic profiles of Chinese provinces.
Diagram 5: provincial variation in debt burden (source)
Reliance on land sales
Further supporting the above narrative is that local government revenue is heavily reliant on land sales; according to one estimate, “land sales accounted for about 30 percent of local government revenue in 2016” (source). The supply of land available for the local government to sell, however, is expected to be fully exhausted by around 2021 (see diagram 7 below).
Increased opacity
Local governments in China are “legally prohibited from borrowing or running deficits” (source) following the 1994 fiscal reforms. So how do local governments escape this oxymoron? While local governments have obtained “much of their debt in the form of bank loans”, then this is not a cause for concern as direct local government debt only increased from 16.5% of GDP in 2006 to 18.6% of GDP in 2013 (ADB, 2014). The main concern comes from opaque financing accessed through shadow banking. Following the stimulus plan announced in 2008 the central government authorized local governments to access debt through formal channels (source). As formal financing channels were not sufficient, local governments increasingly sought credit outside the formal banking system.
One common shadow financing structure is a local government financing vehicle (LGFV), which are enterprises set up by the local government and implicitly guaranteed by the central government. As LGFVs are not officially part of the government they can borrow on behalf of the local government. While the central government is no doubt aware of LGFVs, LGFVs have been overlooked as they have allowed local governments to fulfill their fiscal commitments. The next briefing will include a discussion on the decreasing reliance on LGFVs of local governments.
The increased reliance of local government finances on shadow banking is an issue for multiple reasons, some of which are described below. While estimates of the size of shadow banking are available, it is difficult to have a high degree of confidence in any single estimate given that estimates of the size of shadow banking has a large variance (source). An examination of estimates of shadow bank financing accessed by both government and corporates in 2013 found figures ranging from 8% (Standard Chartered) to 82% (JP Morgan) of GDP, with the average figure being around 50% (source). Another issue is that shadow banking can be argued to embody uncertainty and not risk: although case studies on shadow financing structures can be developed, then it is difficult to develop a credible view on the macro-level risk features of shadow banking. Finally, while LGFVs are widely assumed to be implicitly guaranteed by the central government, LGFV bond yields reflect provincial characteristics such as reliance on real estate, corruption, liquidity indicators and macroeconomic variables (source), indicating that markets do not view the central government implicit guarantee as fully credible. The central government has indeed recently argued that it is willing to let LGFVs fail; while analysts believe that the central government might allow a small number of LGFVs to fail (source), consensus is that widespread defaults would not be allowed.
4. Conclusion
The problem of local Chinese government debt can be traced back to the 1994 fiscal reform, resulting in unbalanced fiscal mandates being forced upon local governments. The problem accelerated following the 2008 fiscal stimulus program, which led local governments to tap the shadow banking system to fulfill a centrally underfunded fiscal stimulus program. While the average national level of local government debt is not worrying by itself, the growth rate, regional variation, reliance on land sales and opacity could be sources of issue in the future.
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