Herbert Poenisch: Local Government Debt：Solved or Postponed?

2019-04-01 IMI

Herbert Poenisch, Member of IMI International Committee, Former Senior Economist of BIS While the announcement by Premier Li Keqiang at the March CPPCC meeting that the bond issue quota for subnational governments in 2019 will be raised to RMB 2.15 tr, an increase of RMB 800 bn, some 30% over 2018 is good news for these government entities. The issue dealt with here is whether this helps solving the local government (LG) debt problem or just postpones the day of reckoning. He also announced some help in maturity restructuring and lower interest rates on this borrowing. This article will give a summary on the current local government debt, the fundamentals of local government expenses and revenues, thus the projected need for incurring debt. It will be argued that a fundamental overhaul of government finances will have to address these issues. Otherwise a winding down of local government debt will not be possible. The LG bonds need to get a remake to make them marketable rather that a duty for captive investors. Finally, institutional investors need to be strengthened to allow them to invest in LG bonds, rather than commercial banks which are over-burdened with fiscal responsibilities. The banks would need additional capital if they continue to cover fiscal deficits. Development of local government debt For a decentralized country like China the government finances are mainly centralized, a contradiction which resulted in local government indebtedness over the years. As local governments were not allowed to go into debt until 2014, they had to rely on intergovernmental transfers, mostly revenue sharing and tax rebate transfers. As their spending from joint and local mandates, such as education, pension insurance, social safety net, housing and investment among others increased significantly in recent years they had to resort to borrowing to cover the gaping deficit. China was an outlier in comparison with other countries, as close to 90% of public expenditure amounting to some 20% of GDP were the responsibilities of local governments. The assignment of responsibilities does not mean that LG have full autonomy in exercising them. They simply act as ‘payment agent’ with little or no decision-making power. This demand could only be financed by local governments resorting to the shadow banking system, through establishing Local Government Financing Vehicles (LGFV). By 2014 borrowing from banks and capital markets through LGFV had increased to some 30% of GDP. Hence the Government decided in October 2014 to allow provincial governments to issue bonds, subject to approval of the NPC. The type of debt instruments were divided into general bonds and special bonds. Special bonds were supposed to be serviced and repaid from the return on investment in projects, however uncertain. Provincial governments were supposed to on-lend the proceeds from bond issues to lower-tier governments that may not report fully the use of funds. The purpose of these bond issues were not only to finance current spending but also to repay LGFV liabilities. As a result, LG bond issuance increased to RMB 14.7tr by end 2017 and RMB 16tr by the end of 2018. By then, LG borrowing had reached the same level as central government borrowing. In total general government bond issues amounted to RMB 32tr (USD 4.8tr), divided in equal shares between central and local government borrowing. In terms of GDP both had a share of 18% of GDP. If one adds the outstanding LGFV borrowing, the total LG borrowing would amount to 48% of GDP, much higher compared with other subnational governments. Based on the official definition which does not include LGFV, China’s local government borrowing is well placed among peers, although somewhat high as percent of total government debt. The relationship between borrowing and debt is unorthodox in China as special bonds are non-debt creating. They are supposed to be served by special income from projects and thus do not count as government debt. Only general bonds count as debt In Li Keqiang’s proposal, out of a ceiling of RMB 2.15tr for 2019, RMB 810bn are special bonds and the rest, RMB 1.25tr are general bonds. While the poorer provinces, such as Guizhou, Liaoning and Yunan issued more debt as percentage of provincial fiscal resources than richer ones, such as Beijing, Shanghai and Guangdong, most of them borrowed up to the threshold stipulated by the NPC. Another feature is that interest rates on LG bonds do not vary much, thus not reflecting the credit risk of individual provinces. The assumption is that central government will bail out any province regardless of its credit rating. Fundamentals of intergovernmental relations A sound system of intergovernmental relations is crucial to China’s continuing development and rebalancing progress. Appropriate allocation of spending responsibilities and funding will be necessary to improve public service delivery, reduce growing regional disparities and promote inclusive growth. The reform of the tax system in 1994 was successful in increasing overall revenues from 12% in 1993 to 22% in 2016. However, the reform also caused LG budgetary surpluses to turn into sustained and growing deficits. The last major reform was in 2014 with the adoption of a new budget law. The new law also allowed for the first time provincial governments to issue bonds for financing capital expenditure, subject to approval by the NPC. It thus closes off the ‘back door’ of opaque finance, such as LGFV and opening the ‘front door’ of transparent bond financing. However, it does not address the fundamental misalignment of expenditure responsibilities and taxing powers, as a result of which the large vertical imbalance has prevailed since 1994. The figures quoted here refer to 2017 (IMF) and 2013 (OECD). China, which counts as a unitary state according to the constitution, mandates LG to finance close to 90 of general government spending. This ratio is higher than any other country in the world, both centralized or decentralized. Even decentralized ones like Switzerland and Russia are well behind China. This reflects the strong involvement of LG in the economy and society. China lags far behind OECD countries and even EME in Asia on all major categories of spending, social assistance spending, health spending and education spending. In other areas such as economic affairs, transport and particularly investment China is ahead of other countries. For the sake of investment, LG, in particular cities have been allowed to issue urban construction investment bonds (UCIB) which have been popular with investors. Although LG collect 60% of total taxes, they can neither set the tax rates nor define the tax base, which is set by central legislation. China relies heavily on indirect taxes which have to be submitted to the central authorities. Shared taxes are corporate income tax and personal income tax. Sub-national taxes are mainly those on real estate, such as the land appreciation tax, house property tax etc. It is not surprising that LG have relied mainly on taxes on the buoyant real estate market as well as on selling land. This allowed them to compete with prestige projects on a local level. However, slower fiscal growth and smaller land sales income add to LG worries during an economic slowdown. For a centralized country the share of grants and subsidies is rather low, compared with other countries such as Japan and France. Some transfers are linked with the successful launch of the UCIB. Other revenues such as tariffs, fees and property income are also lower than in peer countries. Tax revenue as share of LG revenue as well as share of GDP is highest in China. This is particularly so for a country with lower per capita GDP than high income countries. Plotting both, public expenditure of LG and tax revenue, China is the world champion with close to 90% share of expenditure and 60% of tax revenue share. This is the key indicator for fiscal imbalances. As a result of this unbalanced intergovernmental fiscal situation LG resorted to LGFV until 2014 to finance their escalating deficits. As a result China’s LG debt as share of public debt is highest in the world. China’s LG debt is the highest of unitary countries with 20% of GDP and 50% of public debt. China is also the only middle income country to run up LG debt, where only high income countries such as Japan are found. The financing sources are 54% bank loans, 24% LGFV bonds and trust loans. There are other sources for financing infrastructure investment, such as the policy banks, government funds and other resources. Among these are Government Guided Funds and Special Construction Funds. The activities of these funds are opaque, interact with other public sector units and have a strong public policy drive. Every time central government adopts stimulus packages such as in 2008/9 but also recently, LG are given unfunded mandates. This is part of a ‘proactive fiscal policy’ to stimulate economic activities after growth dropped in 2018. As a result the main creditors of LGs are the central authorities, the policy banks and commercial banks which financed LGFV and purchased the bulk of bonds issued by LG since 2014. Under these conditions it is easy to ask the creditors to extend the maturities as well as lower the interest rate on LG liabilities as Premier Li Keqiang has called for in his speech. In a market driven environment this would be very difficult to do. This is only shifting the debt burden from one government controlled entity to another, without resolving the fundamental flaws in the intergovernmental relations. Putting fiscal financing on a sound footing is a major precondition for opening up China’s financial sector. Otherwise, foreign investors will do the cherry picking and leave their domestic competitors to bear the burden of unresolved fiscal imbalances. Reform of the LG financing In order to put LG financing on a sound footing, which will allow bond markets to consider investing in LG bonds the following three reforms need to be implemented. The first one is the reform of intergovernmental finance, the second one is the reform of LG issued bonds to reflect credit risk and third one is to strengthen institutional investors. To address the misalignment of revenue and spending at the LG level, the State Council announced a major intergovernmental fiscal reform which should be complete by 2020. It has three overarching goals: (i) the clarification of expenditure responsibilities to minimize overlapping mandates, improve service delivery and increase accountability; (ii) a recentralization of key functions that are currently under LG control; and (iii) the consolidation and improvement of the transfer system, notably by increasing the fiscal resources of less-developed regions. The major areas where the role of central authorities needs to be strengthened are spending on protection and management of the environment and natural resources, construction and management of the national transportation infrastructure. Social spending which should be addressed on a centralized level includes public pensions and unemployment insurance, but also national health insurance, basic education and social welfare policies to provide a safety net for all Chinese citizens across regions. Strengthening the national pension fund, unemployment fund as well as health fund for both, government as well as private sector workers, not only provides a safety net for the ordinary Chinese but allows these funds to grow into powerful institutional investors. A national provident fund such as in Singapore is also a successful model. Investments of this fund could include providing low cost housing for the low income population. Through all these proposed measures the population will be assured minimum standards in terms of benefit levels, eligibility requirements and targeting, with transfers used to complement local funds and to promote compliance with national objectives. This could be linked with the social credit system. In the transition to a fully funded system, from central and local revenues as well as from individual contributions, LG continue to issue bonds, but in a more market friendly way. At present there is no differentiation between rich provinces and less-developed ones, in the percentage quota as well as in the interest rate. The assumption is that all provinces, regardless of their economic prowess will be bailed out in case of financial difficulties. Monitoring the debt service capacity of provinces is an administrative tool rather than a risk assessment. With big data available, monitoring the revenue and spending patterns of LG should be available to potential investors. Harmonising regulation and taxation of LG bond markets will add to the transparency. However, the reform guidelines are largely silent on the reform of borrowing frameworks. Strengthening potential investors, notably institutional investors should be a priority for financial market reform before opening to foreign investors. These include pension and health insurance funds but also possibly a national provident fund. In addition, allowing the market to set up various market based funds, such as open and closed investment funds, would channel China’s vast savings into orderly channels rather than leave it up to individuals to invest on their own in the capital markets or online platforms. At present, ‘a large pool of RMB denominated savings is held by residents, with M2 over 200% of GDP, and there are insufficient domestic assets in which to invest’. These savings should be allocated into compulsory contributions to the national pension, unemployment, health and provident funds. Again, compliance with these contributions could be part of the social credit system for employers as well as individuals. The remaining savings can be invested in transparent, well supervised investment funds. The task of the government is not only to strengthen these funds, supervise them to avoid fraud, but also inform the population about the need to invest there rather than in speculative funds. It is surprising that individuals are willing to invest in risky stock markets rather than in their personal welfare. Conclusion While the proposed raising of the borrowing ceiling for LG and easing of their servicing burden is a welcome step, it postpones the day of reckoning rather than solving the LG debt problem. A three pronged approach is suggested for putting LG intergovernmental finances on a solid footing, allow market assessment of LG debt and thus remove another obstacle to opening up the financial system.

DOWNLOAD

Herbert Poenisch: Local Government Debt：Solved or Postponed?

related articles

tags