China’s local government debt has been seen as a looming crisis. Following the central government’s recent pledge to comprehensively resolve local government debt issues, the anxious markets experienced a temporary reprieve.
It’s anyone’s guess how big the problem is. After China’s 4 trillion yuan ($556.4 billion) stimulus plan in 2008, local debt began to escalate dramatically. Through the establishment of thousands of local financing platforms, local debt, starting from around 5 trillion yuan, has soared to over 100 trillion yuan in a span of 15 years. Including central government debt, China’s total debt-to-GDP ratio remains, albeit barely, within safe limits. However, the speed of this growth has only rarely been seen globally.
Within this 100 trillion yuan of local debt, implicit debt constitutes over 60%. Implicit debt is what was borrowed by local government financing platforms, taking advantage of the implicit guarantee that came with being owned by the government. While these entities have achieved notable improvements in China’s infrastructure construction and urbanization, they have essentially become a “second treasury” — an unrestricted financial resource for local governments. Consequently, they have become harbors for corruption, which has resulted in some regions carrying a debt burden several times their financial capacity.
Since 2022, some provinces and cities have faced liquidity crises, with Southwest China’s Guizhou province blazing a trail by requesting a 20-year extension on urban investment bonds, of which it will pay no interest for the first 10 years. That caused something of a stir in the markets.
Given the current scale of debt conversion, the central government is reallocating 1.5 trillion to 2.3 trillion yuan of unused local government bond swap quotas to assist 12 provinces and cities facing liquidity issues. The central bank will also provide no less than equal scale liquidity support. Additionally, with the financial system’s optimizations in local debt duration and interest rates, the liquidity of local governments and financing platforms is somewhat restored. Concurrently, the central government has reemphasized fiscal discipline. Localities can no longer take on new implicit debt. This is a reiteration of a fundamental principle that the central government declared in 2018.
Yet, the issue is whether that help is enough. Over the past five years, newly added local implicit debt has amounted to 40 trillion to 50 trillion yuan, with a potential to become a bottomless pit in the future.
Judging from the gap in local fiscal power, the intensity of this round of debt conversion might be insufficient, and liquidity issues are likely to resurface soon.
There have been signs of this recently. Several local government have been struggling to make ends meet, finding it difficult to maintain what central government’s “three guarantees” — those for people’s livelihoods, expenditures and salaries. If central directives continue to be ineffective, it is worth pondering why.
Fundamental solution
Fundamentally, to bridge the gap in local governments’ financial capabilities so they can meet their debt obligations, it is crucial to address the decline in fiscal revenue caused by the economic slowdown. Hence, maintaining steady growth during the transition to high-quality development is pivotal in central government policy planning.
Efforts to break local governments’ reliance on land sales for income must understand that the worst is yet to come.
Why? 2021 marked the zenith for land acquisition, with the delivery of these lands ending around 2024-2025. This, coupled with the impact of the real estate cycle, will likely result in a sharp reduction in relevant tax revenues amounting in the trillions.
The local financial shortfall also encompasses impacts from combating the Covid-19 pandemic over the past three years, creating additional fiscal deficits to address. A study by professor Bai Chong-en from Tsinghua University suggests a total Covid-induced deficit over three years amounting to approximately 4.2 trillion yuan.
However, the reality in China is the absence of surplus at the central level, with 80% of the central revenue allocated for local fiscal transfers. If the central government is to assume local debt issues, seeking aid from the central bank and moving toward the path of debt monetization would be inevitable, with the degree of implementation being the only variance.
This would put the entire country on the hook for paying off the debt, and would lead to considerable moral hazard by rewarding irresponsible local governments for borrowing too much, inducing a vicious cycle. Additionally, taking such significant costs without requisite structural reforms would result in intergenerational debt transfers, which would be extremely irresponsible.
Hence, local debt is not just a fiscal concern. It is a societal conundrum confronted by central and local financial departments, the central bank, the financial system, and the citizenry, necessitating a collective solution.
Path to resolution
Intrinsic mechanisms of unrestricted local debt expansion largely stem from the soft constraints on local finances, which lead to deteriorating fiscal discipline. The current debt solutions are insufficient. Multifaceted structural reforms are pivotal to navigate this impasse, given that neither central government nor markets are panaceas.
How can local fiscal discipline be intensified? From the perspectives of fiscal democracy, legal perfection, and enhanced market constraints, developments have been made in legislative and market constraints, but they lag behind the expansion of local implicit debts.
Breaches in fiscal discipline are common, and largely attributed to the stagnation in governmental reforms and fiscal and taxation system reforms. However, under constant macro tax burdens, reforms in fiscal and taxation systems do not inherently augment financial capabilities. Instead, they alter the revenue distribution ratios between central and local governments, impacting the modus operandi and mentality in their interactions. Ultimately, they determine whether local finances can establish self-balanced fiscal incentive constraint mechanisms.
The so-called fiscal democracy necessitates substantive reviews and supervision of government budgets by local legislatures at all levels, catalyzing fiscal transparency and establishing fundamental notions of local government fiscal balance. There has been progress over the years, but it hasn’t achieved the goals of systemic design, let alone allowing grassroots populations the rights to information, supervision and evaluation of local fiscal operations.
Information disclosure is fundamental for all societal levels to understand the real situation, supervise relevant parties and calculate the costs of different reforms. Information transparency is also a prerequisite for effective market constraints. Nowadays, some argue that all stakeholders of local debts should share the losses. However, discussing loss sharing and its impact on economic growth is impractical without knowledge of the scale of implicit debts, the real number of local financing platforms, and their financial situations.
Recently, local debt has become a significant asset in the bond market, with market players paying attention to various irregularities and illegalities. However, market constraints are extremely limited in the face of omnipotent local governments and absent legal systems.
Currently, the transformation of urban investment is a focus for local governments and the financial system, considered crucial for local financing platforms to emerge from the debt crisis. Both parties barely discuss the boundaries of government investment, the resources used for urban investment, or how to prevent debt evasion, and will continue to avoid these issues whenever possible.
Although local government debt is a global governance conundrum, there are lessons we can refer to.
To create a basic framework for a solution, it is critical to stress to fiscal discipline from top to bottom, fiscal democracy from the bottom up, transparency in information disclosure, effective market constraints, perfection of the rule of law, a more reasonable relationship between central and local finances, and the economy itself seeking a path to high-quality development. All of this calls for a comprehensive reform package. Proper definitions of the essence of the reforms are also needed, like whether the reforms mean adhering to the basic principles of socialist market economy orientation and maintaining openness both internally and externally, to avoid the risk of regressing through undefined, and even unwanted, reforms.
Ling Huawei is the deputy chief editor of Caixin Media.
The views and opinions expressed in this opinion section are those of the authors and do not necessarily reflect the editorial positions of Caixin Media.
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