Overall risk of local government debt in China is controllable, development prospects are bright

By Qiao Baoyun 

Local government debt is a necessary financial tool to support local infrastructure construction. International experience shows that the appropriate division of fiscal expenditure responsibilities between central and local governments is bound to require local governments to play an important role in infrastructure construction and to promote the development of local economy through intergenerational allocation of optimized local government debt resources. With the rapid economic growth, the problem of inadequate infrastructure is particularly acute in the accelerated development of urbanization and industrialization in China, and the role of local government debt has become increasingly prominent.

Local government debt has become a hot topic in China. [Photo: qq.com]

China's local government debt is inherently deficient. International experience shows that local government borrowing is highly risky, and local governments are prone to over-borrowing. The main reason for this tendency is the lack of strictly constrained fiscal relations between central and local governments and inappropriate governance in local government with such problems as "common pool", "soft budget constraints", excessive competition between regions, and the lack of matching funds to complete the tasks assigned by the governments at higher levels. These problems also exist in China. Administrative system, fiscal system and other factors enhance local government's impulse for investment. Especially, the demand for large-scale infrastructure construction emerged in the response to the financial crisis in 2008. Due to the lack of smooth financing channels, the local governments set up a large number of local government financing vehicles for borrowing. The forms of borrowing include bank loans, corporate bonds, trust, BT and so on. During this period, the central government issued local government bonds on behalf of local governments, to explore the establishment of a standard local government debt financing mechanism. In 2009-2014, a total of 1.6 trillion yuan of local government bonds were issued, but far from meeting local demand. The National Audit Office announced that the local government debt increased from 10.7 trillion yuan in 2013 to 15.4 trillion yuan at the end of 2014.

China has gradually established a local government debt management framework in practice. In order to effectively curb the excessive borrowing of local governments, countries around the world have adopted different models to manage local government debt in accordance with the fiscal relations between their central and local governments and their financial market maturity. According to national conditions and learning from international experience, China selects the quota management model. The Opinions of the State Council on Strengthening the Administration of Local Government Debts (Guo Fa [2014] No. 43), the Decision of the State Council on Deepening the Reform of the Budget Management System (Guo Fa [2014] No. 45) and the new Budget Law, which came into force on 1 January 2015, explicitly provide that local government debt is subject to quota management. On the basis of issuing local government bonds to replace the outstanding local government debts as of the end of 2014, the local governments are explicitly required to borrow by issuing local government bonds within the limits approved by the State Council from 1 January 2015 onward, while the local governments and their departments are not allowed to borrow by any other way. At the same time, the State Council establishes a local government debt risk assessment and early warning mechanism, emergency disposal mechanism and accountability system, and orders the Ministry of Finance to supervise local government debts. Overall, the Chinese local government debt management framework is effective. As of the end of 2016, China's local government debt was 15.32 trillion yuan, with the debt ratio (outstanding debt / comprehensive ability to pay) of 80.5%; plus the central government debt of 12.01 trillion yuan, the total government debt was 27.33 trillion yuan. The debt ratio (outstanding debt / GDP) was 36.7%, lower than the level in major market economies and emerging market economies. The overall risk is controllable.

There is still a long way to go for local government debt management in China. Seen from the future development, the following points need attention. First, standardization of debt management is still the focus. It happens sometimes that individual local governments borrow or provide guarantee in violation of laws and rules in various ways, and this may become a major hidden risk. In view of the current typical practice of local governments, namely, borrowing in disguised forms such as service procurement, government guidance fund and PPP, the Ministry of Finance continues to increase efforts and promulgates a series of documents to strictly limit the scope of government service procurement, regulate budget management for government service procurement, prohibit illegal financing by the use of real or fictitious government service procurement contract, require local governments to do a good job of information disclosure for government service procurement, and make clear requirements for various kinds of cooperation between government and social capital in such forms as PPP and government investment fund. In practice, new items may be gradually added into the negative list of local government financing, therefore, standardizing debt management is still a top priority. Second, the development of local government bond market is the direction. Extensive international comparison shows that, to effectively manage local government debt, we must give full play to the role of the market, making the market to play its restraining role in local government financing activities. Through the local government bond market, we should, on the one hand, attract more social capitals to invest in local government bonds, to drive private capitals to support project construction in key areas and stimulate private investment potential; on the other hand, enhance the transparency of local government bonds, protect the legitimate rights and interests of investors, support scientific and reasonable pricing of bonds and reasonable release of risk. The Ministry of Finance focuses on the development of revenue bond products for self-seeking balance between project proceeds and financing, and launches pilot implementation in such key areas as land reserves and toll roads in 2017, upon approval of the 5th session of the 12th National People's Congress. This is a very good start. However, as for now, to further develop the bond market, we also need synchronous improvement of the credit rating system and financial market regulation. Third, exercising strict regulation over the “back door”. The 'front door' is opened for local government debt, while the 'back door' of borrowing in violation of laws and rules by some local governments has not been closed completely. To solve this problem, the Ministry of Finance adopts a series of measures including risk early warning and intensifying the efforts to investigate and handle the law-breaking activities and keep the persons concerned accountable. Without local self-discipline, regulation and restraint alone can only be a temporary solution rather than a permanent one, and may even become a "cat and mouse" game. For example, from the perspective of fiscal relations between central and local governments, on the one hand, unclear division of authorities and expenditure responsibilities may easily lead to the emergence of unreasonable investment projects; on the other hand, the repayment liability may tend to be left to the next government, resulting in serious moral hazard and incentive incompatibility. To establish a long-term mechanism to prevent local government debt risk, it is not enough to strengthen management alone. We also need to further deepen the reform of fiscal system and economic system, in particular the transformation of government functions, to establish a more reasonable fiscal relations between central and local governments and make local governments change their mind from daring not to touch the red line to being not willing to touch the red line. At present, China is steadily promoting the reform of fiscal relations between central and local governments, and has achieved positive results in this respect. 

The local government debt development is not smooth in almost all countries. The work to prevent local government debt risk cannot be done once and for all. The challenges to local government debt management in China are like growing pains. China has clear reform goals. It is believed that China can continue to identify problems, understand problems and solve problems in practice.

(Qiao Baoyun, Chinese Government Debt Research Center, Central University of Finance and Economics)