Defusing China’s Local-Government Debt Bomb

The finance ministry’s budget report to the National People’s Congress contained the line, “local governments face debt risks that cannot be overlooked”. It was buried deep in the text but caught this Bystander’s eye for the red flag raised by its very understatement. Beijing is now looking very hard and directly at those risks.

A nationwide flash audit of provincial and municipal governments’ borrowings, both direct and indirect via captive investment vehicles (also known as financial platform corporations), was launched at the beginning of this month, Caixin reports. Eighteen teams of auditors have four months to complete it.

Finance ministry officials and bank regulators have been concerned for sometime about the risks involved in the 7.7 trillion yuan ($1.2 trillion) of bank loans made to local governments’ captive investment vehicles as of June 30th, with 23% not backed by cash flows.  The China Banking Regulatory Commission (CBRC) discovered in February that more than half of new bank lending wasn’t meeting its new credit rules designed to mitigate the fear that China’s banks are sitting on a potential dung heap of bad loans; its concern was particularly acute about direct and indirect lending to local governments.

The unexpected new audits suggest that the concern over the debt risk to local-government finances is deepening, and that, perhaps, the numbers have worsened significantly since last June, intensifying a general concern in Beijing about the overall weakness of local-government governance. The finance ministry has cataloged the points of vulnerability:

We are fully aware that some prominent problems concerning fiscal operations and management still exist, the main ones being: Some county and township governments remain in rather difficult financial circumstances, and assurances of adequate basic funding for them have to be strengthened. The system for ensuring that financial resources are correlated with responsibilities still has yet to improve, and the task of making basic public services uniform between regions and between urban and rural areas is quite arduous. The fiscal and taxation policies for promoting the transformation of the pattern of economic development need further improvement, and public finance must play a larger role in adjusting income distribution. Local governments face debt risks that cannot be overlooked. Management of revenue and expenditures from the sale of land-use rights urgently needs to be strengthened. Fiscal management remains weak, and the pace at which expenditures are made throughout a fiscal year is not sufficiently uniform.

What is needed is an intensified pace of structural reform. Central government policy under the new five-year plan sharpens the focus of economic development to provide social services and public welfare projects to narrow the regional inequality gaps and blunt the corrosive inflation seen as so threatening to political stability. Provincial and local governments will be the vehicles for delivering much of that. Last year, for every yuan that central government spent directly, local governments spent four and a half yuan (though 44% of local government’s revenue comes from Beijing in the form of tax rebates and transfer payments). This is a huge tail wagging the dog.

Beijing doesn’t want the dog dropping dead because the tail implodes. So the finance ministry is sounding tough about getting to grips with local-governments’ debts:

We will strengthen supervision of local government debts and strive to guard against financial risks. We will promptly set up a system for the overall management and dynamic monitoring of the debts of financing platform corporations , and standardize management of these debts. We will accelerate the establishment of a mechanism to control the scope of local government debts and a mechanism to warn when they get too large, and promote the standardization of local governments’ debt financing.

Easier said than done given China’s sprawling local bureaucracy, and it will require a change to rewarding local officials for promoting economic growth above all and to local government’s dependence on land-sales for revenue. But none the less urgent for that. In 2011, Beijing plans to increase the amount of money it will hand over to local governments by a budgeted 15.3%. In all, local-government spending is budgeted to increase 11% from 2010’s levels. The finance ministry will cover a collective 200 billion yuan local governments deficit with bond issues.

Local governments can expect to be increasingly under Beijing’s thumb to be accountable for the money they are getting. They can also expect unrelenting reform of their finances and governance. The finance ministry has already said that  that it will “eliminate all extra-budgetary funds and place all government revenues under budgetary management.”

None of this will be particularly comfortable for local officials used to the mountains being high and the emperor far away. The transparency the reforms imply, if it can be brought about, will also make the dipping of local hands into the honeypot of public money more difficult — another potential source of discomfort. None can say they are not getting fair warning. But if China’s local-government debt bomb explodes first, that will be the least of everyone’s worries.