Leaders in Beijing acknowledge that center-local fiscal reform is critical, and that it has a long way to go in China. Reform plans promised to close the gap between what the center commands local governments to spend and the resources available to them. Fiscal gaps contribute to resource misallocation, suffocating debt, inefficiency, public services underinvestment, industrial overcapacity, local resistance to reforms, and deteriorating growth potential. In 2014, leaders approved fiscal reforms and a 2016 deadline for “basically” finishing major tasks. Those deadlines slipped.
To gauge fiscal reform progress, we watch the gap between local government expenditures and the financial resources available to pay for them, including central government transfers. Our primary indicator shows the official trend in blue and an “augmented” calculation of the gap including off balance sheet, or “extra-budgetary,” expenses and revenues in green – thus covering the range of estimates. The higher the expenditure-to-revenue ratio is, the more concerning the side effects, including debt burdens. Our supplemental fiscal indicators include local financing sources, the national official and augmented fiscal position, the move from indirect to direct taxes, and the share of expenditures on public goods, each of which is discussed below.
Quarterly Assessment and Outlook
There were no major changes in the center-local fiscal picture in the third quarter, and the root causes of high levels of debt among China’s subnational governments remain unresolved. Increased bond issuance brought in important new revenue, slightly narrowing their fiscal gap but at the cost of more debt.
A new rental housing policy and strenuous environmental efforts, despite their laudable intentions, will inevitably weigh on local budgets. Premier Li Keqiang reiterated commitments to advance reform to the fiscal regime in September, but no major new policies were presented in 3Q2017. President Xi sent a strong signal about the Party’s desire to shift toward slower and more sustainable growth at the 19th Party Congress in October. Yet, Beijing also appears committed to hitting its pledge to double the size of the economy from 2010 levels by 2020. That will require an average 6.2% annual growth rate from 2018 to 2020.
Taken together, there is a clear need for significant reform to China’s fiscal regime, given high local government debt levels paired with unrelenting mandates to deliver growth and satisfy ballooning social spending obligations. So far our data reflect little progress on this front.
This Quarter’s Numbers
Our primary center-local fiscal indicator shows the official expenditures-to-revenue ratio at 111.8%, down from 112.7% in the previous quarter, thus an 11.8% gap. Including extra-budgetary items, the augmented fiscal ratio is 144%, down from 145.7% in 2Q2017 but still highly elevated and near the top of the range in our five-year monitoring window.
New local government non–placement bond issuance in the third quarter totaled RMB 1.4 trillion, a jump from RMB 999 billion and RMB 174 billion in 1Q2017 and 2Q2017 – the second-highest quarterly issuance since the program’s inception in 2015. Land reserve bonds, a new type of local government bond backed by land holdings, were introduced in July and already accounted for 11% of the non–placement bonds issued in the third quarter (RMB 159 billion).
The strong bond issuance numbers in 3Q2017 were shaped by central policy at the start of the year. Issuance in the first half was below 50% of the annual quota, in line with central bank tightening efforts. Local governments thus had room to expand issuance in 3Q2017 while staying within quota. As seen in Sources of Local Government Financing, this bond financing was a major portion of local government funding in the third quarter. As the outlook for monetary policy turned more neutral, yield curves stabilized and bond markets strengthened (the three-year bond average yield was 3.828% in 3Q2017, lower than 3.832% in 2Q2017).
Budgetary revenue also recorded double-digit growth for the first time this year (10.4% year-on-year (yoy), up from 4.3% in 2Q2017) due in large part to low base effects from last year. On the expenditure side, in 3Q2017 fiscal spending decelerated, growing only 3% yoy, down from 13.5% in the previous quarter. This reflects front-loaded local government spending in the first half of 2017, and spending quota constraints in 3Q2017. Extra-budgetary infrastructure spending slowed as well, growing by 13.8% yoy in the third quarter, down from 16.4% in 2Q2017.
“Local government-managed funds” – another quasi-budgetary item counted in our augmented fiscal ratio – exhibited high growth in both expenditures (44.8% yoy vs. 28.2% in 2Q2017) and revenues (44.1% yoy vs. 34.5% in 2Q2017). A big portion of these government-managed funds relates to land and property transactions, either purchasing or selling. In the third quarter, more existing housing inventory was sold than newly constructed units, which, coupled with anecdotal evidence from domestic media, suggests the government was directly buying properties that developers were not able to sell.
While a 4% deficit reading as suggested by the official measure would stand China in responsible company with Japan and the United States, a nearly 17% augmented measure would put China in extreme territory.
Other supplemental indicators provide additional perspective. Our data on the Official and Unofficial National Fiscal Deficit show that China’s central fiscal deficits, both official and through our own calculations (augmented deficit), also remain high. On a four-quarter moving average (4qma) basis, the official fiscal deficit in the third quarter was 3.9% of GDP, while the augmented deficit was 16.3% – only slightly improved from 16.7% in 2Q2017. While a 4% deficit reading as suggested by the official measure would stand China in responsible company with Japan and the United States, a nearly 17% augmented measure would put China in extreme territory.
China’s direct taxation ratio (see Moving from Indirect to Direct Taxes) grew, largely thanks to value-added tax (VAT) reform, which offered a moderate cut in indirect taxes and was fully implemented in 2Q2016. Yet China remains well behind Organization for Economic Cooperation and Development (OECD) averages for the share of direct taxation in the economy. Direct taxes are generally more business friendly but more difficult to collect, so developing countries often rely on them less. China’s ratio rose to 30.8% in the third quarter, from 30.2% in 2Q2017, compared to an OECD average around 60%.
Finally, as spending on other items slowed, social welfare outlays increased in 3Q2017 as a share of total fiscal spending on a 4qma basis (see Government Expenditures on Social Spending as Percentage of Total Expenditures). In the third quarter, all four categories we monitor (education, social security, health and family planning, and environmental protection) received a higher share of total fiscal spending, with the four collectively accounting for 38% of outlays, up from 37% in the second quarter. Though a modest change, this is positive directionally, which we will continue to monitor closely in future quarters. Given that overall expenditure growth decelerated to 3% yoy this quarter, from 13.5% in the second quarter of 2017, this suggests the government slowed spending elsewhere (e.g., infrastructure), while satisfying its hardwired social welfare obligations.
Policy Analysis: 3Q2017
On September 28, the State Council held a VAT symposium to review the program and discuss future tax policies. Premier Li Keqiang concluded that following VAT success, the government must now “quickly advance central-local fiscal reform.” His remark was likely in response to rising demands from local officials for fiscal relief, as the successful implementation of VAT reform effectively reduced subnational tax revenue by about 10% – a reality that was supposed to be offset by other elements of tax and fiscal reform but so far has not been. Other than Li’s acknowledgment of the priority, 3Q2017 did not see practical movement toward that goal.
On July 18, nine ministries, including the National Development and Reform Commission and the Ministry of Finance, issued a joint notice announcing a pilot program for building out public rental housing units in 12 cities. This program is expected to improve growth quality by increasing the housing supply and reducing pressures that contribute to property bubbles. However, local governments’ fiscal interests still depend on land transfer fees paid by property developers into fiscal accounts. Faithful implementation would weaken the land-financing model and force governments to turn to other, potentially riskier methods, such as local government financing platforms to fund their infrastructure and social spending obligations.
While carried out with laudable intentions, the government’s environmental efforts also risk a fiscal headache. Improving air quality requires reductions in the production and use of steel, coal, and cement – and Beijing pushed for better compliance in the third quarter. In 2016, despite already deep cuts, air quality in areas with heavy concentrations of high-polluting industries failed to meet desired air improvement targets. This suggests an even more assertive push in 4Q2017. For local governments relying on tax revenues from heavy manufacturing, such as Shanxi and Hebei, cleaner air will mean fiscal challenges.