True size of Beijing's deficit matches Japan's black hole

International Monetary Fund analysis that adds debt of China's local governments to national balance sheet reveals shocking discrepancy

PUBLISHED : Wednesday, 12 June, 2013, 12:00am
UPDATED : Wednesday, 12 June, 2013, 3:56am

Most analysts, when they look at the economic challenges facing China, end up noting that no matter how daunting the problems, Beijing enjoys a far healthier budget balance than the governments of the world's other major economies.

Unfortunately, the Chinese government's fiscal position may not be quite as enviable as they believe.

At first glance, Beijing's balance looks strong. According to figures from the Ministry of Finance, central and local governments ran a combined budget deficit of 800 billion yuan (HK$1 trillion) last year. For a country that boasted an economic output of 52 trillion yuan in 2012, that equates to a government deficit of just 1.5 per cent of gross domestic product.

That's well below the 3 per cent of GDP level regarded as prudent. And compared to the budget deficits run last year by Japan and the United States, it looks positively insignificant.

What's more, with tax revenues at a relatively modest 19 per cent of GDP, the official figures imply that Beijing has plenty of leeway to boost its revenue collection to plug any emerging budget gaps and to fund future spending.

But, as so often in China, the official figures tell only part of the story. Although the official numbers cover both central and local government budgets, they fail to reflect that much of local government spending is off-budget.

Constrained in their ability to issue debt in the capital markets, China's local governments typically fund their infrastructure projects through arm's-length companies.

Known as local government financing vehicles, in recent years these entities have borrowed vast sums of money, often through China's shadow banking system.

Add this off-budget borrowing back into the government's fiscal position and the picture changes drastically. In their latest Article IV consultations with the Chinese authorities, analysts from the International Monetary Fund tried to do exactly this, coming up with figures for what they called China's "augmented fiscal deficit" and its "augmented government debt".

Factor in borrowing by local government financing vehicles as well as local governments' net revenues from land sales, and, according to the IMF, China's government deficit shoots up from 1.5 per cent of GDP last year to 10 per cent.

To put that into perspective, as the first chart below shows, that's higher than the monster deficits run by Washington and London, and on the same order of magnitude as Tokyo's budgetary black hole.

Similarly, China's gross government debt - excluding pension obligations, liabilities of regular state-owned enterprises and contingent liabilities in the state-owned banking sector - shoots up from 23 per cent of GDP to almost 50 per cent.

It could be argued that these "augmented" figures are not especially worrying. Debt levels remain low, and fiscal reforms would do a lot to iron out China's government deficits.

Nevertheless, the numbers are troubling. Such heavy borrowing by local governments to fund pet infrastructure projects risks crowding out the more productive private sector.

The figures also emphasise how much China's economy is still driven by high levels of fixed-asset investment. According to detailed data released last month, the contribution of household spending to China's GDP last year was flat at 35.7 per cent, while the share of fixed investment climbed from 45.6 per cent to a record 46.1 per cent.

In other words, after years of policies aimed at rebalancing, China's economy remains as distorted as ever because of massive off-budget investments by local governments. If Beijing's new leaders really want to create a more sustainable economy, they will first have to push through fiscal reforms to rein in the local governments. Without fiscal reform, there can be no rebalancing.