07/24/2015
China / GDP
The debt build-up in local governments has prevented China from using of more aggressive fiscal policy to arrest the economy’s slide. But reforms are underway.
China’s current tax sharing system, which was established in 1994, resulted in fiscal deficits for many local governments. While national revenues are almost equally divided between central and local governments, the latter are responsible for more than 80% of national government expenditures.
Up until 2015, local governments had limited autonomy to derive needed revenues, for example, by introducing new taxes or by issuing bonds. Instead, they made up for shortfalls through requesting transfer payments from the central government, selling land, and borrowing from banks. These practices created problems ranging from waste of resources through transfers, unfair land expropriation and associated over-investment in property, as well as large piles of opaque debts raised from local government financing vehicles. This debt build-up has prevented the use of more aggressive fiscal policy to arrest the economy’s slide.
Faced with this, the Chinese government has embraced new strategies to fund public spending since the beginning of this year. These include allowing local governments to issue bonds and promoting public-private-partnership (PPP).
But many challenges remain. Even though it has been more than three decades since PPP’s inception in China, an inadequate legal environment, frequent changes to regulations, and incongruent central and local government statutes continue to hinder the PPP’s development.
Another key challenge – common to both PPP and local government debt issuance – is drawing the line between the state and the market. Both initiatives infuse market elements into the realm of public finance, but there is a tendency for the government to dominate the scene in a planned economy. Too much government intervention could smother efficiency improvements and deter private investors.
A guiding principle is that the market should have free discretion to make commercial decisions. Therefore, the government’s key role would be to nurture a favourable institutional and administrative environment – one that safeguards investors’ interests and that clearly delineates the role of the government and the market.
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