Overview
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
In initial drafts of this Dashboard edition, we intended to slightly upgrade our assessment of the state of China’s fiscal reform program in light of modest improvement in our indicators in recent quarters. However, with newly available data from the Ministry of Finance (MoF) in front of us, we find that local government fiscal conditions are even more strained than our earlier conservative estimates. While revised data suggest slight improvement in the fiscal landscape in recent quarters, conditions are so much worse than previously estimated that we selected not to improve our score this period.
The 2013 Third Plenum Decisions sought to balance fiscal resources between the center and local governments, professionalize the budget management process, and improve tax collection. Our primary indicator gauges local government fiscal conditions by tracking the gap between local revenues and spending. The indicator shows that local governments spend significantly more than they collect in revenue, revealing that Beijing’s commitment to better balance center-local fiscal resources is unfulfilled. While our conservative estimate in the Spring 2018 edition was that local governments spend 43% more than all revenue they collect, new MoF data show the number is actually 55%! This situation encourages risky and irregular financing practices by local governments and increases underlying risks. The gap measured in our primary indicator has improved modestly for four consecutive quarters, and supplemental indicators show that central government transfer payments to local governments were the highest on record in 1Q2018. These data are directionally positive, aligned with 2013 reform commitments and may lead us to upgrade our assessment in future editions if they continue.
Policy developments suggest Beijing is focused on limiting risks rather than wholesale fiscal regime reform. The government cracked down on public-private partnerships (PPPs) as it became clear that many participating “private” entities were actually government financing vehicles, defeating the purpose of using PPPs to alleviate local fiscal burdens by attracting more private sector participation into development projects. Beijing also encouraged new types of bond issuance for local governments, an effort to develop alternative and lasting revenue streams for local governments and alleviate over-reliance on land sales and risky financing mechanisms. Other needed structural fiscal reforms – such as the development of new tax revenue streams for local governments – made no real progress.
Policy developments suggest Beijing is focused on limiting risks rather than wholesale fiscal regime reform.
This Quarter’s Numbers
The MoF began to release monthly local government bond data in December 2017. These data provide previously unavailable information that allows us to more accurately measure the discretionary funds local governments receive from issuing bonds. We also recalibrated our estimation of local government infrastructure spending in this edition, after 2017 full-year data were released. The most notable result of these calibrations is that the gap between what local governments receive in revenue and what they spend is even worse than our earlier conservative estimates, particularly in the period between 2015 and 2017.
We look at local government fiscal conditions as the basis for our assessment of China’s fiscal reform process, given that local governments account for roughly 85% of national government spending. The primary indicator in 1Q2018 shows that local fiscal conditions are bleak, and even more so with newly updated data available. When accounting for extra-budgetary items, the augmented local fiscal ratio is 154.6%, down from 156.6% in 4Q2017. This means local governments spend 55% more than all the revenue they take in, even when accounting for central government transfers and debt issuance. Official budget numbers put this ratio at 108.9%, down from 111.0% in 4Q2017. The discrepancy between these official budgetary numbers and our extra-budgetary calculations speaks to continued opacity in China’s fiscal system.
To improve fiscal health, local government revenue growth must outpace spending. According to our calculations, when extra-budgetary revenues and expenses are counted (including proceeds from land sales and bond issuance), the picture is indeed improving, albeit slowly: total local government revenue grew by 13.1% year-on-year (yoy), while expenditures grew by 10.2%. In other words, revenue growth is modestly outpacing expense growth in our aggregate measurement. This means improving local government fiscal health – an important 2013 Third Plenum objective. One local government expense item, infrastructure spending, fell sharply in 1Q2018, growing by just 5.1% yoy, down from 9% in 4Q2017. This represents the slowest growth in the past six years in this category. This happened as the government increased scrutiny to prevent the misuse of PPPs in funding development projects (discussed below). It is also consistent with a shift in the focus of policy efforts to deleverage debt risks from financial institutions onto local governments, a trend we highlighted in the last Dashboard edition.
The biggest positive in this quarter’s data was growth in central government transfer payments, as displayed in Sources of Local Government Financing. This is a step toward matching spending mandates and resources, a key policy goal. In 1Q2018, these transfers reached RMB 2.2 trillion, a 23% increase yoy, up from -1.5% in the previous quarter. First quarter upticks are normal, but this is the largest since 2015. Transfer payments in the quarter were 10.9% of the size of the whole Chinese economy – the highest reading since 2011.
Such an increase does not come without trade-offs. By alleviating local fiscal stress, Beijing transfers responsibilities and burden onto the central government’s budget. But the central budget is less strained than provincial ones; in the context of China’s fiscal reform agenda – which prioritizes rectifying structural imbalances more than limiting deficits per se – such a realignment of responsibilities is positive.
As with our primary indicator, our measurement of China’s augmented national fiscal deficit is improving modestly. The supplemental indicator Official and Unofficial National Fiscal Deficit counts all the augmented revenues and spending considered in our local government assessments discussed above and then compares those to the government’s official deficit data. Among other things, a nation’s fiscal deficit is an important signal of the government’s policy orientation toward growth – whether it is trying to boost or cool the economy. By counting augmented flows to and from local governments, our indicator attempts to convey a fuller picture of the fiscal landscape than does official central government deficit data. The official fiscal deficit was 3.5% of GDP in 1Q2018, down from 3.7% in 4Q2017. The augmented calculation, which considers off–balance sheet local government spending and revenues, puts the deficit at a much higher 15.3% of GDP, down from 15.9% in4Q2017. This indicator has been decreasing for four consecutive quarters but is still significantly higher than pre-2015 levels of closer to 10%.
Another set of 2013 Third Plenum fiscal reform objectives was to make government budgets more standardized and transparent. A debt-swap program underway since May 2015 encourages local governments to swap other liabilities for bonds and to increase (non-swap-related) bond issuance generally, instead of relying on riskier financing mechanisms like the underregulated local government financing vehicles (LGFVs) that have played a notorious role in recent years. Greater reliance on public bond issuance would alleviate risks and also align with the objective of improving fiscal transparency. But no non-swap local government bonds were issued in the first quarter. This is partially seasonal, as the brief history of the program shows that first quarters typically have low issuance. The program itself is also a trial initiative set to expire in the second half of 2018. This could drive a significant increase in issuance in the second and third quarters, as local governments rush to exhaust their quotas before the program ends.
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 such as sales or services taxes. The OECD average is for direct taxes to account for more than 60% of overall tax revenue; in China that number is currently just 29.7% (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. That is not occurring. 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 1Q2018 on a four-quarter moving average (4qma), at 37.0% from 37.2%. This number should be moving up given demographic trends, but fiscal shortfalls limit room for flexibility.
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. That is not occurring.
Policy Analysis
The most positive policy trend this period was continued increase in central transfers to local governments. At the March 2018 National People’s Congress, Beijing announced that it would increase central transfer payments by 9% this year from the 2016 level. Since then, the Ministry of Education reported an increase of RMB 13 billion in education transfer payments in May, and the State Council announced that RMB 100 billion of poverty reduction funds had been transferred to local governments through the end of April, two months ahead of schedule. Also in May, the MoF urged provincial governments to accelerate fiscal transfers to city- and county-level governments. These developments are all in line with commitments to rebalance center-local fiscal burden sharing.
Policy trends also show that mitigating local government debt risk is a top priority. We highlighted in the last Dashboard edition that the central government’s deleveraging efforts, initially focused on the financial sector, would focus more on local governments and state-owned enterprises this year. The Communist Party’s Political Bureau Standing Committee (PBSC) reaffirmed this publicly on April 23.
As part of deleveraging, the central government tightened scrutiny of PPPs in the first quarter. Since an MoF circular “On Regulating the PPP Project Library” was issued in November 2017, local governments have decertified 1,160 PPP projects, totaling RMB 1.2 trillion. The Xinjiang Autonomous Region (a provincial-level administrative area) alone accounted for 222 of the 1,160 decertified projects; in early April, Xinjiang issued a blanket suspension of all PPP projects that involved government fiscal commitments, even for projects where construction had already started. This large-scale cleanup of PPP projects drove the sharp fall in infrastructure spending seen in our data for the quarter.
Another important tool for improving local government fiscal conditions is allowing local governments to issue more bonds for financing. The Ministry of Housing and Urban-Rural Development (MoHURD) announced a new local government “shantytown development” bond in April, meant to be used for redeveloping poorer urban areas to house China’s newly urbanized population (China will add another 255 million urban residents between 2018 and 2050, according to the United Nations World Urbanization Prospects report). Shantytown bonds will be the third type of municipal bond instrument, after toll road bonds and land reserves bonds, that local governments are green-lighted to issue to fund investment projects. However, the process got off to a slow start: in the first two months after the MoHURD announcement, no shantytown development bond was issued.