China’s fiscal conditions are on an unsustainable path. Local governments spend much more than they take in, forcing them to rely on inefficient state-owned enterprises, land sales, and risky debt practices for revenue. This increases underlying risks and makes the economy less efficient. A transformation of the country’s central-local fiscal regime is needed to align resources and shore up local fiscal coffers, particularly given the looming demands of an aging population.
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
Our indicators show that China’s fiscal reforms are stagnant, elevating the potential for sharp growth deceleration and local debt crises. Local authorities shoulder 85% of subcentral spending obligations but retain only 50% of total government revenue. Official reporting shows the local government debt stock at RMB 16.5 trillion ($2.5 trillion at 2017 exchange rates) at the end of 2017 (20% of GDP) – a big number, but one that fails to count myriad unrecognized liabilities. Independent figures estimate local government debt two to three times higher, between RMB 30 and 47 trillion ($4.6 and 7.2 trillion), or 40%–60% of GDP. The central government’s fiscal conditions are healthier, giving Beijing capacity to absorb some of this debt in the future. That will be necessary.
Efforts to recognize local government liabilities are incomplete, and central government transfer payments are not remotely large enough to offset current local shortfalls. The ongoing deleveraging campaign (see Financial System) is exacerbating the fiscal strain. Local governments have only a few months left to replace informal, off–balance sheet borrowing with “swap” bonds, but markets are still unsure what prices for these obligations should be due to lack of policy clarity. Programs allowing local governments to replace high-interest debt with lower-cost bond debt will probably continue in 2019 and beyond, but no announcements have been made. Regional credit distribution is hugely uneven, and some localities barely have enough new credit to cover interest payments on old debt held by local government financing vehicles (LGFVs). Most outstanding local government debt is in the form of LGFV obligations such as loans, asset management products, and corporate bonds issued with the implicit understanding that governments would back them. It is increasingly likely that local government obligations in some areas will default.
Inability to roll over existing debt is one scenario that could cause a broader crisis. A wave of defaults could spread from overleveraged regional banks through the financial system via interbank lending markets connecting banks across the country. Beijing could rush to bail out localities suffering in such a scenario (as we noted above, Beijing does have some capacity to absorb local government debt), but quick contagion of interbank markets would cause significant economic damage. Besides, Beijing does not want to bail out all localities: fiscal reform to illuminate which liabilities are and are not guaranteed by local governments is the whole point. Any way you look at the fiscal picture, the present degree of stability is unlikely to persist.
Inability to roll over existing debt is one scenario that could cause a broader crisis. A wave of defaults could spread from overleveraged regional banks through the financial system via interbank lending markets connecting banks across the country.
This Quarter’s Numbers
This quarter’s augmented Local Expenditure-to-Revenue Ratio continues to show a dangerously wide gap: expenditures equal 152.4% of fiscal revenue. This figure includes extra-budgetary items and is not significantly different from 1Q2018. Official figures cite a ratio of 109%, practically unchanged from 1Q2018. The official ratio, however, understates the actual budget gap by excluding LGFV liabilities, as everyone is aware.
The high expenditure-to-revenue ratio partially explains why infrastructure investment by local government-linked firms is weaker in 2018. Official data place infrastructure investment growth at only 0.2% year-on-year (yoy) in 2Q2018, but the actual decline from a 2012–2017 average of 18.5% is probably not that severe and can be attributed partially to methodological revisions by the National Bureau of Statistics (NBS).
Our gauge of the Official and Unofficial National Fiscal Deficit shows little change. The official fiscal deficit was 3.3% of GDP in 2Q2018 (versus 3.5% 1Q2018), while the augmented national deficit was 14.4% (15.3% in 1Q2018). Recent methodology changes to central government fixed-asset investment data cast doubt on this improvement in the augmented measurement. The government’s annual fiscal deficit target is currently 2.6% of GDP for 2018, making it likely that reported quarterly fiscal deficit figures fall even more in the quarters to come.
Sources of Local Government Financing shows a mixed picture. Net local budgetary revenue is the sum of taxes, central transfer, and other revenue-generating measures like land sales. Growth of these revenues slowed to 4.3% this quarter, down from 10.6% in the previous quarter. Tax revenues were up while central government transfer payments were down sharply from the start of the year. What buoyed local finances were government fund revenues, mostly land sales, up 40.5% yoy. However, there are reports of officials booking land sales prematurely to paper over solvency concerns (see Land). Alternate real-time proxies suggest land sales growth just half as strong.
In terms of financing, finally, issuing debt is not the same as revenue – because it has to be paid back! Yet, despite the national priority to deleverage and curtail “bad” local debt provision to LGFVs, moving local government financing to the “front door” of what in the United States would include, for example, municipal finance bonds is an important objective. New bonds of this sort issued to roll over existing local debt rebounded to RMB 333 billion ($48 billion) in 2Q2018 after zero issuance in the prior quarter. This is one way to meet capital needs while pursuing fiscal discipline. Local government revenue bond issuance should continue growing but will be prone to volatility as investors and regulators go through increasingly frequent bouts of anxiety about financial crises.
China relies on indirect taxes – like the value-added tax (VAT). Beijing has acknowledged that direct taxes, such as the individual income tax, are more efficient, but these only constitute a small portion of overall tax revenues today. Our indicator of China’s Direct Tax Ratio, currently at 29.9%, is less than half of the OECD average (62%). This has increased only slightly over the past six years (from 25% in 2012). Indirect taxes are easier to collect and require less sophisticated infrastructure, such as legal and accounting systems, so it is common for developing countries to rely on them. The trade-off is that they are less effective especially when Beijing is exploring tax-cut options to support growth. Since the tax burden on households and small businesses is indirect taxes and nontax costs, income tax and other relief does little.
China faces inevitable demographic challenges, with an aging population set to increase social welfare obligations. Currently, however, local governments are struggling to maintain even their current levels of social spending. Our indicator of Government Expenditures on Social Spending shows the ratio of social expenditure in total government expenditure is 37.5% in 2Q2018, slightly up from 37.1% in 1Q2018. This has improved only 3% in the past six years, much slower than the rate required by demographic changes.
The central government’s forthcoming policy guidance will be one of the first indications of where Beijing will attempt to cap its own responsibilities for debt management, and where the burden will be placed on localities.
Local government debt is a focus of the deleveraging efforts. National guidelines for managing this problem are expected soon, and these will have a big effect on central-local fiscal reform. Domestic media reported in early August that local governments received debt management guidance (not yet publicly available) jointly issued by the Party and the State Council. The content of this guidance would determine (1) how much, and what, debt the government will recognize as official liabilities; (2) the roadmap to resolve these liabilities; and, potentially, (3) the fate of those liabilities that are not recognized.
These are critical questions with implications for local governments and market participants, including banks and holders of LGFV-issued bonds. Local government revenue bonds issued directly since May 2015 are explicitly acknowledged as government obligations. Most outstanding local government obligations are not in the form of bonds, or even unambiguously issued by government, and the original idea of the Ministry of Finance’s (MoF’s) 2015 debt swap program was to restructure this mishmash into clearer government obligations at lower interest rates.
LGFV debt including loans, asset management products, and corporate bonds were issued with an implicit expectation that government would back them, and hence these are referred to as “implicit” liabilities. The debt swap program is set to end in late 2018, but it is clear that local governments have not yet swapped most of their implicit debt. Several localities have reported that their implicit liabilities are double or triple the level of their explicit debt.
Since 2015 the National People’s Congress (NPC, China’s legislature) has imposed a 100% debt-to-revenue ceiling on local government debt. This means it is impossible to recognize all implicit local liabilities, as this calculation would likely exceed the 100% debt ceiling in most localities. As a result, local governments may eventually have to shirk responsibility for a portion, rattling financial markets. The central government’s forthcoming policy guidance will be one of the first indications of where Beijing will attempt to cap its own responsibilities for debt management, and where the burden will be placed on localities.
The MoF has been working to separate LGFVs from local governments since 2017. On August 13, a financing vehicle affiliated with the Xinjiang Production and Construction Corps (XPCC, a quasi-government institution) defaulted on a 270-day bond. The bond issuer was not technically an LGFV, but the local government implicitly guaranteed its debt. As these defaults increase, market expectations of government guarantees for LGFV debt will change, altering the value attached to many assets. In this case, because another related company was seeking to sell bonds relatively soon, full payment of the bond was made only one day later, and Party discipline officers launched an investigation against the LGFV’s management. This sends mixed messages to local officials who are considering backing away from LGFV-related obligations.
At the same time, Beijing has started to look for countercyclical fiscal policy options, as the deleveraging campaign threatens to bend growth rates below the comfort zone. On July 13, Xu Zhong, research bureau director of the People’s Bank of China (PBoC, China’s central bank), openly criticized China’s fiscal policy settings as “not proactive.” The State Council announced on July 23 that it would use “proactive fiscal policies” to stabilize the economy, and a July 31 statement following a Politburo meeting on economic conditions also announced that “fiscal policy needs to play a bigger role in expanding domestic demand and structural adjustment.”
These signals led to some misplaced market speculation over the potential for larger-scale fiscal stimulus. Deleveraging will remain an overriding goal for the foreseeable future, because it is about urgent systemic risks, not just countercyclical goals. “Fine-tuning measures” to ease the adjustment pain are likely to be limited and can include monetary easing to facilitate regulatory tightening (see Financial System). This process requires PBoC assistance to free up additional deposits currently locked up on the central bank’s balance sheet.
Another potential fiscal policy option to stabilize the economy is tax cuts. Theoretically, cutting the individual income tax rates could support household consumption at the margin. MoF submitted a draft for individual income tax reform to the National People’s Congress Standing Committee (NPCSC) on June 19. The bill proposed to raise the annual standard deduction from RMB 42,000 to RMB 60,000 ($6,000 to $8,600), to offer more tax deduction options, and to adjust tax brackets. Domestic media reported that the government wanted to accelerate tax reform, with a trial phase in late 2018 before complete implementation in 2019. However, as noted above, the impact would be limited given the low proportion of direct taxes in the tax base. Individual income taxes in particular only reflect around 6% of China’s overall tax revenues, or a bit more than 1% of GDP. Public reactions so far indicate the tax cut appears insignificant, a sentiment echoed by some members of the NPCSC expert panel.