• Sun
  • Dec 28, 2014
  • Updated: 1:58pm
CommentInsight & Opinion

Local government debt shows needs to reform financial and tax system

PUBLISHED : Tuesday, 07 January, 2014, 3:03am
UPDATED : Tuesday, 07 January, 2014, 3:03am

Analysts have long cited a lack of transparency in local government borrowing activities on the mainland as reason for deepening unease, given the disclosure in 2011 that by the end of 2010, local authorities had run up total debt of 10.7 trillion yuan (HK$13.6 trilion). It has turned out to be a well-founded concern. In a long-awaited report ordered by the State Council, the National Audit Office says local government debt, including contingent liabilities and guarantees, had risen by nearly 70 per cent to 17.9 trillion yuan by the end of June. While this may not mean that China is facing a crisis, it has raised serious concerns about the health of the country's economy and the debt problem generally.

To put the figure into perspective, the debt of the central government, which takes the lion's share of public revenue, stood at 12.4 trillion yuan. Starved of revenue, local government has accumulated trillions in debt for infrastructure investment, partly from the largely unregulated shadow-banking sector. The audit report shows that shadow banks accounted for at least 13 per cent of all local government borrowings. This adds to the concerns of global investors about the extent to which loans have turned sour. The NAO's report follows the findings of the latest quarterly China Beige Book (CBB) survey, which said the proportion of new credit, as opposed to loans to roll over unpaid debt, had shrunk for the seventh consecutive quarter. Only 14 per cent of the bankers questioned in the CBB survey said 30 per cent or more of their branch lending went to new customers in the fourth quarter.

Mainland officials may say that the current debt level is manageable, and local officials know Beijing will bail them out. But the significant rise is really cause for concern as local authorities go on a spending spree on infrastructure and other projects financed by heavy borrowing. There is already anecdotal evidence that many Chinese cities are basically bankrupt because they cannot repay their debt. The financial stress accounts for local governments' extensive and often heavy-handed involvement in land dealing. Researchers at the China Index Academy forecast local authorities' land sales revenue would hit a fresh record above 3 trillion yuan this year as they try to raise enough funds to meet their obligations. Local government debt reflects the urgent need to reform China's financial and tax system, including the division of revenues between local authorities and the central government.


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'But the benefits of an international currency --- low borrowing costs and reduced exchange rate risk --- should eventually prove too alluring for the Chinese authorities to ignore.'
(From the FT, 'Era of renminbi dawns as China's influence grows')
An even more important reason to issue local-government municipal bonds, and central government treasuries for that matter, is to further develop China's debt market --- a necessary (but not sufficient) condition for developing Renminbi into one of the world's investment and reserve currencies.
Without a well-developed debt market, the living standard of the American people couldn’t have been so high relatively (being unable to fully use the wealth of other countries), and Pax Americana as we know it couldn’t have persisted for such a long time --- even after the 2008 crash.
Usually the government debts are rolled over, seldom ‘paid off’.
The incentives of the local politicians must be changed so that their demand for debts becomes smaller and interest-sensitive.
It’s better to issue longer-term municipal bonds that better match the maturities of assets and liabilities, and that are professionally rated by the credit rating agencies --- presently China’s credit rating agencies tend to overrate those debts.
With interest rate liberalization, the behaviour of the local politicians will then be guided by the local residents in the free bond market.
Those local government debts are not as 'bad' as we think. While some of them will become bad loans, the others remain self-liquidating in the long term.
Superficially the rates of return (3% to 4%) of the local governments' projects seem to be too low, but we should also consider the beneficial externalities of those projects, like the convenience and better environment created from building the roads, bridges, tunnels, MTRs, piazzas, and so on.
The total combined rates of return are not that low actually.
If the local provinces and governments are not starved of cash, they will become too independent and powerful.
These too-big-to-govern local politicians may then become as uncontrollable as the feudal lords in the late Tang Dynasty.
Beijing will then become a lame duck.
Even periodically replacing their leaders doesn't really help --- the orders will simply be neglected.
The threat of China's dividing into a few countries, especially with the help of the foreigners, can't be discounted.
Economics and politics are always intertwined.
There are political considerations as well.
That's why economics was originally called political economy.
Ricardo's most famous work is his Principles of Political Economy and Taxation (1817).
Macroeconomics came first, followed by microeconomics.
Like it or not, it's a hard fact of life.


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