The essential financial reform Beijing cannot afford to ignore
Abolition of a mainland agricultural tax boosted farming a decade ago, but also helped to create a massive local government debt pile
The 10 years of Hu Jintao's presidency from 2003 to 2013 are often described as a period of policy stagnation for China.
Sure, the economy expanded at a stunning rate, growing almost fourfold in real terms during Hu's time in power. But following the upheavals of the late 1990s, when Beijing drastically pruned back state-owned industries, cutting millions of jobs, the pace of domestic liberalisation slowed right down.
It didn't stop entirely. Hu and his premier Wen Jiabao were credited with one major reform. Starting in 2003, right at the beginning of their time in office, Hu and Wen scrapped China's 2,600-year-old agricultural tax.
At the time observers praised the tax's abolition as both farsighted and liberal-minded. Freed of the hated tax, farmers were encouraged to invest more in their land and to increase their use of fertiliser. Over the next couple of years, China's output of grain per farm-worker rose by almost 20 per cent. Incomes rose, and rural per capita consumption climbed 24 per cent. After years of lagging behind, the living standards of China's farmers finally began to close the gap with those of its city-dwellers.
But the reform had less desirable effects as well. The revenue from agricultural tax had been earmarked by Beijing as solely for the use of local governments. Following hard on the heels of the tax reforms of the early 2000s, which compelled local governments to hand over 60 per cent of their business income tax revenues to the central government, the abolition of the agricultural tax blew a major hole in local government finances.
Aware of the problem, Beijing offered revenue transfers to local governments to plug the gap. Somehow the promised transfers never quite offset the local governments' losses, leaving them seriously out of pocket.
That posed a major problem for local officials. Their career prospects hinged on how successfully they could generate economic growth in their townships and counties. And to generate growth, they needed to invest heavily, above all in new infrastructure.
Yet Beijing's rules prohibited local governments both from borrowing directly from China's banks or from issuing bonds. As a result, they had to come up with another way of raising money.
The abolition of the agricultural tax suggested an answer. Since the tax had been scrapped, as far as officials were concerned farmland no longer had any value in terms of generating regular income. On the other hand, they could sell it to private companies for development. Even better, they could set up their own companies and hand them the land use rights, which they could then use as collateral against bank loans to fund infrastructure development.
So local government-backed investment companies, often called local government financing vehicles or LGFVs, were born. Things started in a relatively modest way, but from around 2005 onwards the pace of land seizures in rural areas picked up.
Activity accelerated further in 2009, when Beijing ordered a massive economic stimulus effort. Across the country, local governments injected former farmland into LGFVs which borrowed against it to fund the construction of new roads, waterworks, industrial parks and thousands of the glittering property developments which began springing up everywhere.
China's state banks were happy to lend. After all, the borrowers were tied to local governments, which meant they were surely good for the money. And of course officials were enthusiastic borrowers. They were following orders and promoting growth.
The resulting borrowing bonanza was unprecedented in scale. According to an official audit published last month, in June last year local governments were sitting on an enormous 18 trillion yuan (HK$22.88 trillion) in debt. To put that sum into perspective, it's equal to more than 30 per cent of China's 2013 gross domestic product. According to research from the Royal Bank of Scotland, it's enough to push the country's total government debt up to around 57 per cent of GDP. Other estimates put the total size of the government's potential liabilities almost twice as high.
The pace of this debt expansion is making the central authorities nervous. Last year Beijing instructed banks to cease lending to LGFVs with poor financial prospects. However, much of the lending is off-balance sheet, conducted through China's shadow financial system, and the evidence suggests lenders would rather roll over short-term loans than trigger a wave of defaults.
The only sustainable solution is a fundamental shake-out. Viable LGFVs should be restructured and spun off to operate commercially, at arms-length from local governments. Non-performing LGFVs should be brought back on to their balance sheets, with Beijing, and possibly the banks, bearing some of the pain of write-offs.
And most importantly, China's fiscal system should be overhauled, so local governments are no longer responsible for 85 per cent of overall government spending on just 50 per cent of the revenues.
No one advocates a re-imposition of the old agricultural tax, but a failure to solve local governments' financing problems soon could easily risk undermining the rest of Beijing's modernisation programme.