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  • Aug 21, 2014
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Monitor
PUBLISHED : Tuesday, 28 January, 2014, 1:27am
UPDATED : Tuesday, 28 January, 2014, 1:27am

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

BIO

As the writer of the South China Morning Post’s Monitor column, Tom Holland attempts each day to make sense of the latest developments in business, finance and economic affairs in Hong Kong and mainland China.
 

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.

Local governments’ borrowing bonanza was unprecedented in scale

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.

tom.holland@scmp.com

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whymak
Very good discussion here, both from Mr. Holland and reader "singleline."
singleline
Policy above, tactic below.
In this respect the genius of the Chinese people is perhaps the greatest in the world!
The local politicians will have a much greater preference than now to overexaggerate their locality's GDP, for obvious reason.
Care must be taken by Beijing to prevent them from doing so.
singleline
Well, rule is one thing, whether it's strictly adhered to is another.
I think not even Germany strictly observes the rule mentioned downstairs.
In China, it's perhaps easier to do so --- violating the rule means no promotion, and the leading local government officials in the present term are fully held responsible for the violation.
singleline
The Stability and Growth Pact in the Eurozone requires all members to have deficits below 3% of GDP and public debt below 60% of GDP (Maastricht criteria).
To deleverage the local government debt, it is critical to set up a deficit and debt cap for the local governments.
Once the debt cap is established, some measures including selling government assets, securitizing debts, and wiping off by the central governmennt are needed to be taken immediately to quickly lower the leverage rates below or close to the target rates.
Other measures including issuing local government debt, levying property taxes, and rebalancing expenditure will be long-term solutions for a healthy and sustainable local fiscal position.
(To know more you can read 'Strategic Priorities, China's Reforms and the Reshaping of the Global Order' by Yifan Hu, P.145)
singleline
No matter.
China can grasp the opportunity to further develop a deep and sophisticated debt market, so that China’s pension funds, insurance companies, mutual funds and later the foreign countries’ sovereign wealth funds (they are mostly long-term investors) can invest in the central government’s treasuries and the local governments’ municipal bonds.
China can then fully utilize the hard-earned wealth of the other countries to her advantage.
It also paves the way for developing Renminbi as one of the world's investment and reserve currencies in the future.
The recent (and past) emerging market turmoil is partly caused by the EM countries’ not having deep and sophisticated bond markets, because their economic size and population are not large enough (unlike those of the US and China).
So they often rely on the import of foreign capital and investment for their economic needs. Once the money leaves en masse, we witness the crises like the present one.
But unlike the small countries, China has the potential to develop a deep and sophisticated debt market to minify the effect of massive capital flights after she has fully opened her capital account.
(Usually the short-term punters will quickly move their money out.)
 
 
 
 
 

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