BEIJING IS MAKING another attempt to rein in wasteful public spending at the local level. It is restricting the cash transfers it makes to local governments to bridge a structural gap in China’s public spending: local governments responsible for 80% of public spending, but raising only 50% of public revenues.
More than two-fifths of those covering cash transfers are for specific projects. Beijing now wants to bring the share to below 40% to impose more discipline on local governments in their spending, which is running at levels causing increasing concern to central policy makers. Some estimates put local government debt levels as high as 22 trillion yuan ($3.5 trillion) as of the end of last year.
Local administrations have long been reliant on land sales to raise their revenue. However, the cooling of the property market has cut revenues from that source, and the real fiscal impact of that is only now being felt. As much as one-fifth of outstanding local government debt may be tied up in projects that ought to be written off, according to some estimates.
Few local administrations have access to the nascent municipal bond market. For some years, most have been using off-balance sheet financing through captive special investment vehicles, causing a ticking time bomb of local government debt to build up across the country. The audit of these investment vehicles’ liabilities conducted late last year reportedly puts them 30% to 40% higher than at the time of the previous audit – levels that were perturbing enough then.
This fiscal ordinance is all the more dangerous because of the weakening property market. Some 40% of local government debt is pledged against future land sales revenues. Beijing tightened the screws on local government’s off-balance sheet lending late last year when the China Bond Clearing House said it would not consider paper issued by such vehicles as equivalent to government issued bonds.
That is a prelude to phasing out off-balance sheet financing and bringing more transparency to local government finances. It has already decimated, in the correct use of the word, new issuance, from more than 100 billion yuan ($16 billion) a month to 10 billion yuan.
That staunches the flow of new lending but doesn’t heal the wound. The prospect for the first half of this year is that local governments will find their finances squeezed in a way not experienced by many local officials in their working lifetimes.
China’s local government finances are a creaking edifice facing if, not collapse, at the very least an increasing likelihood of something once unimaginable de facto defaults. That puts the stability of the whole financial system at risk. Central government would step in to prevent defaults that threatened systemic risk, but it underlines the urgency of the need for Beijing to press ahead with its plans for comprehensive reform of local governance financing.