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
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. The 2013 Third Plenum Decisions promised to improve debt management and increase the central government’s role in spending to alleviate pressure on local governments. But our indicators show that little progress was made in the review period. Our primary indicator looks at the gap between what local governments spend and the revenues they collect. The data show that local governments spent 43% more than total local revenues, close to an all-time high, and that central transfers to local governments actually fell from the previous quarter.
The central government is cognizant of its fiscal dilemmas, and policy momentum to address underlying risks is accelerating. Beijing set a slightly more austere deficit target for the year at the National People’s Congress, promised to diffuse local government debt risks, cracked down on the misuse of public-private partnerships as a financing source for local governments, streamlined tax collection by consolidating state and local tax bureaus, and committed the central government to sharing more of the burden for local social welfare spending. These developments look good on the surface, but in many ways they either codify existing practice or promise to implement existing regulations, rather than fundamentally overhauling China’s fiscal regime. Rectifying the wide gaps revealed in our indicators will likely require policy shifts of greater magnitude.
This Quarter’s Numbers
We look at local government fiscal conditions as the basis for our assessments of China’s fiscal situation, given that local governments account for roughly 85% of national government spending. Our primary indicator assesses the gap between how much local governments are spending and their total revenues, and it compares officially reported numbers of that gap with an augmented ratio that counts extra-budgetary items such as infrastructure spending and land transactions. The indicator this quarter suggests that local fiscal conditions remain dire: when accounting for extra-budgetary items, the augmented local fiscal ratio is 143.3%, practically unchanged from 143.9% in 3Q2017. This means local expenditures are 43% higher than all revenues, even when accounting for central government transfers and debt issuance. Official data put the ratio at 111%, down from 111.8% – a more modest shortfall that reveals a wide discrepancy between formally announced numbers and realities on the ground as captured in our augmented assessments. The augmented local fiscal gap is close to an all-time high of 145.7% from 2Q2017 and is not currently improving.
Local governments need to spend less and collect more revenues, either directly or via transfer payments from the central government. Both local government spending and revenue growth slowed modestly in the review period.
Spending growth slowed slightly more than revenue growth, meaning that the gap between the two narrowed slightly in the right direction – but that was not material enough to improve our indicators. Spending growth was 2.8% year-on-year (yoy), down from 3% in 3Q2017, and estimated infrastructure spending growth was 10.3% yoy, down from 13.8% and the slowest in the past 20 quarters. This occurred for two reasons and neither had to do with reform progress. First, the government spent more money earlier in 2017 to stabilize growth ahead of the 19th Party Congress in October, meaning fewer resources were available in the fourth quarter. And second, numerous high-profile local public infrastructure projects were suspended late in 2017 after a string of local fiscal revenue falsifications was made public. For example, in November 2017 heavily indebted Inner Mongolia halted work on two major subway projects; in January, the province admitted that its 2016 fiscal revenue data were overstated by 26%.
The central government has a key role to play in alleviating local fiscal pressures by increasing the amount of money it sends to local governments – which was a key reform commitment of the 2013 Third Plenum Decisions. But our Sources of Local Government Financing indicator reveals that transfer payments from the central government to local governments actually decreased from the previous quarter – the exact opposite of the policy direction promised to put China on a more sustainable fiscal path. Central transfers fell by -1.5% in 4Q2017, after growing 2.5% in the previous quarter.
Bond issuance by local governments also decreased, despite a stated intent to use the bond market as a more transparent and sustainable funding vehicle for local governments than the off–balance sheet revenue streams captured in our augmented measurements. New local government non-placement bond issuance was RMB 705 billion, down from RMB 1,382 billion. This resulted from deleveraging efforts, which increased borrowing costs and thus made bond issuance less attractive for local governments.
Local government fiscal data, as captured in our augmented measurements, also lend credibility to a more negative assessment of China’s overall national fiscal conditions. Our supplemental indicator of the Official and Unofficial National Fiscal Deficit counts all the augmented revenues and spending considered in our local government assessments discussed earlier, and then it compares those to the government’s official deficit data. While the official fiscal deficit was 3.7% of GDP in the fourth quarter, the augmented calculation, which considers off–balance sheet local government spending and revenues, puts the deficit at 15.9% of GDP, significantly higher than pre-2015 levels closer to 10%. That paints a much bleaker picture of the country’s fiscal health.
As Beijing looks to shore up fiscal revenue, it should also be increasing the share of taxes paid directly to the government by businesses and individuals (direct taxes) as opposed to relying on indirect taxes applied by intermediaries (such as sales or services taxes). The Organization for Economic Co-operation and Development (OECD) average is for direct taxes to account for more than 60% of overall tax revenue; in China that number was 29.9% in the fourth quarter and did not improve in all of 2017 (see Moving from Indirect to Direct Taxes).
Finally, as China’s population ages and the country develops a more market-based, higher valued added, and services-oriented economy, the share of overall government spending on social welfare items should increase, while the share spent on areas such as industrial policy should fall. Yet our indicator of Government Expenditures on Social Spending as Percentage of Total Expenditures shows that the share of social spending in government expenditures was essentially unchanged in 4Q2017 on a four-quarter moving average (4qma) basis, at 37.2% from 37.6%, still the second-highest reading in our 20-quarter observation window. This number should be moving up given demographic trends, but fiscal shortfalls limit room for flexibility. Three out of the four categories we monitor (education, healthcare, and environmental protection) received a smaller share of total government expenditures. Social security was the only category that saw its share increase in the review period.
If meaningfully implemented, policy efforts to limit the nation’s deficit and diffuse local government debt risks should drive improvement in our fiscal indicators.
Numerous policy developments during our review period make clear that Beijing is cognizant of its fiscal dilemmas. The Ministry of Finance (MoF) set out a more austere budget position and committed to “proactively prevent and defuse the risks posed by local government debt” in its annual report delivered to the National People’s Congress (NPC) in early March. The report set a deficit target of 2.6% of GDP, or RMB 2.38 trillion, down from 3% last year, and promised to impose debt caps and block “illegal and rule-flouting borrowing” by local governments. Closer to the writing of this Dashboard edition, in early April 2018, the Communist Party’s newly elevated Financial and Economic Affairs Commission (previously a leadership small group before the NPC) said that it would focus on deleveraging local government debt this year. If meaningfully implemented, policy efforts to limit the nation’s deficit and diffuse local government debt risks should drive improvement in our fiscal indicators.
In its annual report to the NPC, the MoF also proposed 9% yoy growth in central transfer payments to provincial governments, up from 7% last year, with the majority allocated to primary education, social security, housing, and healthcare. This is a piecemeal step meant to address the inadequacies in the central fiscal transfer regime, and it falls short of the kind of comprehensive overhaul needed to address the roots of the problem. The NPC also passed a State Council institutional reform plan that merged state and local tax bureaus in a bid to allocate revenue more efficiently and improve local fiscal transparency by limiting data falsifications.
Beijing also cracked down on the misuse of public-private partnerships (PPPs) in an effort to curb illicit local government financing. But until the central government takes on much more of the spending burden and gives local governments viable alternative funding channels, such practices are inevitable and will continue to recur. On November 10, 2017, the MoF published a circular entitled “On Regulating the PPP Project Library,” which barred investment projects that “did not pass fiscal sustainability tests” or “failed to establish any performance-based payment mechanism” from receiving PPP certification. The National Development and Reform Commission (NDRC) also took steps to encourage private participation in PPPs. Local governments had been using local government financing vehicles (LGFVs), which are quasi-official government financing channels, as “private investors” in PPP projects. This meant that many PPPs were entirely government funded despite the central government’s intent to better utilize private investment.
Finally, on January 27, 2018, Beijing announced a change to the central-local fiscal regime that commits the central government to taking on more spending responsibility for social welfare items. On the surface, the change appears to represent one of the few serious fiscal policy reforms in recent years. Yet we are cautious about whether it will drive meaningful improvement in our assessments. Issued by the State Council as a “Reform Plan on the Center-Local Shared Fiscal Responsibilities in Basic Public Service Areas,” the plan specifies funding responsibilities between central and local governments in eight categories: compulsory education, student financial assistance, employment assistance, endowment insurance, healthcare insurance, public health and family planning, social assistance, and public housing. It also adopts a new calibrated system that categorizes each of China’s 31 provincial governments based on its fiscal strength. The intent is for the central government to increase fiscal allocations to the provinces where funding is most needed. But the eight “basic public service” categories account for only 10% of overall local fiscal spending. And many of the supposedly new measures in the plan that would increase central government disbursements to the local level are already happening, such as the promised 20%–80% local-central share of the burden for funding public compulsory education.