Can Beijing limit the spread of China's debt disease?

Local government debt is a growing problem in China, and working out how to cope with it is one of Beijing’s biggest challenges.

Burgeoning local government debt is a cancerous tumour weighing down the health of the Chinese economy, and figuring out how to manage the growing burden is one of the biggest challenges facing Beijing.

The State Council, the Chinese cabinet, last week issued a comprehensive set of directives designed to improve transparency, clarify the responsibility of debtors and put a lid on the overall size of the debt during the National Day holiday.

Before examining Beijing’s effort to rein in its debt problem, it is useful to remind ourselves just how bad the situation is. The collective debt of local government soared nearly 3.9 trillion yuan, or $720bn, to 10.6 trillion by June 2013, according to the last comprehensive survey by China’s National Audit Office.

Local governments have also explicitly guaranteed 2.7 trillion yuan worth of debt. In addition, they are also expected to shoulder at least part of the 4.3 trillion yuan liabilities incurred by other corporate and semi-official entities.

The total size of local government debt including official debt, and explicit and implicit loan guarantees, amounts to 19.6 trillion yuan or about one third of China’s GDP. But there is scepticism around whether the official figure is an accurate representation of the country’s alarming debt problem.

The three-page policy document from the State Council has three elements:

Empowering provincial level governments to raise their own debt

Until recently only the Ministry of Finance, a central government agency, was allowed to issue debt. As a result, Chinese local governments have turned to local financing vehicles to raise debt to build their own pet projects, from bridges to cloud-computing centres.

Beijing recently amended its budget law to enable provincial governments to issue their own debt. However, lower-tier governments at municipal and country levels are still not permitted to raise their own debt.

Though the central government has relaxed its grip on local governments’ ability to raise debt, there remain numerous limits on how much they can raise. The Ministry of Finance and the local People’s Congresses will set the upper debt limit for provincial governments after taking into account their existing level of debt as well as their repayment ability.

The new policy also makes it clear that local government debt issuance should only be used to raise money to build utilities and basic infrastructure and reduce debt levels. However, the local government is not allowed to issue debt to cover recurring expenses.

Addressing moral hazard

One of the key reasons behind the explosive growth in local government debt is the widely held assumption that the cash-rich central government, which has nearly $US4 trillion worth of reserves, would bail out troubled local governments.

However, the newly issued policy document makes it explicit for the first time that the central government will not bail out local government. It seems that Beijing is determined to address the problem of moral hazard, a term describing how behaviour changes when people are insured against losses.

Beijing wants to impose tougher fiscal discipline on its local governments. One of its key measures is to make senior officials more accountable for their fiscal spending. The policy says if the central government was ever needed to bail out a local government under extraordinary circumstances, the most senior official from the local government must be hold accountable.

Though Beijing wants to address the problem of moral hazard, it also outlines that if a local government exhausted all of its resources including selling off of all of its assets, then the central government could come to the rescue. But the head of the local government would pay a hefty price.

The ability to manage debt will also be included in the key performance indicator matrix that is used to assess the promotion prospect of party cadres. This measure is introduced to clamp down on the incentives for local officials to borrow and leave the debt to their successors to handle.

Clarification of debt responsibility

As evident from the National Audit Office’s survey, Chinese local governments have explicitly and implicitly guaranteed 7 trillion yuan’s worth of debt on behalf of corporate and semi-government entities. This makes it difficult to assess the full scale of the debt problem as it blurs the line of responsibility between government debt and corporate loans.

This has been exacerbated by the fact that until recently, local governments were not allowed to issue their own debt. In the future, Beijing demands that there must be a clear delineation of government and corporate debt. Local governments are forbidden to raise money from corporate platforms and at the same time, companies are not allowed to shift their debt burdens onto governments’ balance sheets.

In a press conference after the release of the policy document, Ministry of Finance officials explained that local governments must withdraw from commercial real estate projects and liquidate their debts through market mechanisms. Beijing is also urging a greater use of private and public partnerships to ease the funding burden of local government.

How Beijing manages it local government debt burden will be crucial to engineer a soft landing for the world’s second largest economy and Australia’s most important trading partner.