Among the ills afflicting the Chinese economy, a few are particularly deadly: the ballooning local government debt is one of them. No one knows for sure how massive it is, or how risky.
The nationwide audit that began this month will help to shed some light on these questions, but to stop risks growing past a tipping point, China must institute a system of debt control. This is the root cure, and is urgently needed.
Local governments have long struggled with indebtedness, but the problem was compounded by Beijing's post-2008 stimulus injection. Of the estimated local government debt of 10.7 trillion yuan in 2010 (HK$12.2 trillion then), more than 49 per cent was accumulated in the two years from 2009.
Any warning signs apparently went unheeded, as local governments tried to stay afloat by borrowing more. Since 2010, despite orders by both the State Council and various regulators to toe the line, the advent of "creative" financial products and policies have allowed officials to exploit any and every loophole. As a result, rising debt levels have created not only stress in the banking system, but also the existence of a massive shadow banking operation.
Borrowing more to pay off a debt is no solution, of course. But local governments do it partly because they really need the money, and it's fair to say most give no thought to how the money may be repaid. This is a result of "soft budget constraints", when politics - not economics - guides decision-making. The reasons for this are complex, and it's a hard habit to break. But the consequences are dire; indebtedness today grows quickly into crisis proportions.
Reforms - not mere tinkering - are urgently needed. And this requires leaders' resolve.
First, fiscal management must improve. After the audit makes clear the level of existing debt for each government at all levels, officials must clarify the level of their off-balance-sheet debt and debt-to-gross domestic product ratio, as well as set a cap on debt growth.
Local governments must also submit their finances to public scrutiny as part of democratic development. They must keep the relevant people's congress posted of their overall debt level, the growth rate of new debt and the level of debt risk, and the legislature can veto any rise in debt if it does not like the figures.
Government budgets must also demonstrate foresight; the well-being of our future generations must not be compromised by officials seeing only near-term needs.
Improving the financial market is also a goal. To this end, the government should promote the healthy growth of a bond market. The pilot scheme to allow six regional governments to issue and market their own bonds is a step in the right direction, but with the exercise seen as being backed by the central government, the interest rates of these bonds do not reflect their real risks and potential gain.
A better way is for city governments to issue bonds, since city governments will be directly spending the money raised, and the market can better fulfil its ability to set prices. Such bonds can also be sold to the city's residents, who would decide whether to buy based on consideration of their own pension and welfare needs. Their decision would act as a constraint on runaway debt.
In such a market, the authorities should allow bad debts to default, provided there is no risk of systemic failure. Only in this way can we avoid the moral hazard of "too big to fail". The 1999 bankruptcy of state-owned Guangdong International Trust and Investment Corporation is a good example to remember.
Ultimately, to curb local government debt, officials must be encouraged to make the right decisions. Hence Beijing must broaden the criteria for their performance appraisal, away from a single-minded focus on GDP numbers towards attention on the quality of growth and balancing the fiscal books.
Some officials recently suggested holding government officials accountable for the accumulation of too much debt. This and other proposals are worth considering. The central government must seriously study how it could address the problem of irresponsible decision-making, with sensible, effective rules.
In the end, a sound debt control system depends on clear rules of governance - backed by law - that spell out the respective responsibilities of the central and local governments. This means establishing a clear relationship between their finances, and a clear line of command. While a legal framework may take time to set up, such a move towards rule of law will help prevent local governments from blindly borrowing more money. For one, it makes clear Beijing will not be responsible for paying their debt.
High fiscal debt is a problem faced by many major economies, and China may learn from their experience. But given its unique mix of problems - a slowing economy, greying population and shaky market foundations - China must seek its own solution. It will take time, but the work must start now.
This article is provided by Caixin Media, and the Chinese version of it was first published in Century Weekly magazine. www.caixin.com