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A cockle farmer trudges through a muddy field near the Meizhou Bay bridge, which is under construction as part of the Fuzhou-Xiamen high-speed railway project, in Putain, Fujian province, China, on February 8. Local governments have poured funds raised by the floating of bonds into infrastructure projects. Photo: Bloomberg
Opinion
Yukon Huang and Joshua Levy
Yukon Huang and Joshua Levy

China’s local government debt may not cause a financial crisis, but it poses a huge fiscal challenge

  • China must boost its tax rates and realign tax and expenditure responsibilities so local governments become less dependent on revenue allocations from Beijing and land sales to finance their expenditure
Some months ago, panic was beginning to set in as Chinese bond defaults surged. Since then, investor nerves have steadied, but a crisis has not been totally averted. The defaults of state-owned enterprises (SOEs) and local government financing vehicles (LGFVs) are stories about debt. But the usual debt statistics conceal far deeper fiscal problems than the typical banking vulnerabilities in other economies.
On the face of it, China’s debt statistics offer a mixed picture in terms of risks. Household debt has risen steadily over the past decade to around 60 per cent of GDP, but this is comparable to other economies and driven by the emergence of a more prosperous middle class and a vibrant housing market. Government debt (central and local combined), at around 45 per cent of GDP, is only about half that of the United States.
The category that does raise concern is corporate debt, which at around 150 per cent of GDP is unusually high and largely driven by SOE borrowing. But these numbers are misleading – they include debt issued by LGFVs, which are classified as SOEs but differ from other state-owned companies in their activities.

This phenomenon is an outgrowth of China’s skewed fiscal structure. In China, provincial and municipal governments lack broad taxation powers; those are jealously guarded by Beijing.

Yet, the central government relies on its local counterparts to fund and provide the bulk of infrastructure and social services. So, provinces are chronically short of revenue but burdened with spending obligations.

For many local governments, establishing LGFVs allows them to spend beyond their restricted means. That debt is better categorised as government liabilities than corporate debt.

Local governments have poured the funds raised by the floating of bonds via LGFVs into infrastructure projects. In 2000, the levels of fixed asset investment undertaken by SOEs that were locally and centrally run were similar.

Debt clamp down raises risk of China’s first local government defaults

By 2017, enterprises controlled by local governments were doing over 20 times as much investment as those directed from Beijing, reflective of consistent budget shortfalls.

Whereas the magnitude of the increase in investment would be untenable in other countries, China’s local governments have access to a unique financing option: land. Because land prices have skyrocketed in recent decades, LGFVs have been able to borrow aggressively against land assets which serve as collateral.

As long as land assets were appreciating more rapidly than interest rates were climbing, local governments could keep rolling over their debt.

At some point, defaults of LGFVs and other SOEs might be a legitimate reason for worry, perhaps as harbingers of a broader financial crisis. But that is unlikely.

S&P Global Ratings downgraded the creditworthiness of some, but not all, LGFVs last April when pandemic-related lockdowns were at their peak in China. The rating agency noted that much of the LGFV debt is effectively guaranteed by provincial governments.

So, even when changing the outlook of several such bonds to “negative”, S&P noted that the likelihood of extraordinary government support had increased to “almost certain” or “very high”.

The People’s Bank of China has kept interest rates at historic lows, partly in response to the pandemic. This has made it easier for SOEs to roll over their debt, reducing the chances of widespread collapse.

Zero-tolerance approach to bond issuers after slew of defaults, China says

Beijing has expressed a greater willingness to let some SOEs, including LGFVs, default on their debts. But that hardly translates into carte blanche to abandon all (implicitly) government-backed borrowing.

Notably, the highest profile defaults – Yongcheng Coal & Electricity, Tsinghua Unigroup, and Huachen Automotive Group – provide private, not public, goods. That is, the firms not being rescued can be readily replaced by competitors.

Even in an unlikely worst-case scenario, if all LGFVs had to default on their outstanding debt simultaneously, a purchase of those toxic assets worth 9 trillion yuan would increase the government debt-to-GDP ratio by 12 percentage points.

This calculation doesn’t consider the second-order ramifications or the liquidity effects it might have on interbank lending. But with quick PBOC intervention, a worst-case fallout could be contained.

A man works at a BMW Brilliance Automotive plant in Shenyang, the capital of northeast China’s Liaoning province, in February 2020. The debt default of the company’s parent made headlines globally. Photo: Xinhua
Financial contagion and crisis, then, are probably not on the cards. But LGFV defaults are symptomatic of deeper structural problems. For one, the surge in land values is running out of steam. Second, for a still relatively poor country, investment as a share of GDP in excess of 40 per cent is no longer sustainable given the steady decline in investment productivity.
Many governments globally have decided they can afford to take on more debt. But that is not a reason to abandon fiscal reforms. As China’s population rapidly ages, social expenditure will rise even as productivity gains shrink. Both central and local authorities will be stuck in the double bind of a reduced tax base and mounting expenses.
China needs to deal with two structural fiscal challenges. One is that, on average, China’s tax rates are barely half that of Organisation for Economic Co-operation and Development nations.

The other is to realign tax and expenditure responsibilities so local governments become less dependent on revenue allocations from Beijing and land sales to finance their expenditure.

China’s local government debt problem is now seen as a “grey rhino” economic risk. Unless these issues are resolved, China may find itself stuck in a middle-income trap.

Yukon Huang is a senior fellow at the Carnegie Endowment for International Peace. He is author of Cracking the China Conundrum: Why Conventional Economic Wisdom Is Wrong. Joshua Levy is a junior fellow at the Carnegie Endowment for International Peace

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