Revamping China's fiscal system

Wall Street Journal

Contrary to popular belief, banks aren't the source of China's major economic headaches. They're merely the accommodators. The real culprit is the current fiscal system.

Consider the debt issue first. Beijing's fiscal policies limit local governments' share of tax revenues to about 45 per cent, even as local governments account for 85 per cent of state expenditures (up from 65 per cent around 2000). This has forced local governments to fund their social and infrastructure spending via off-budget financing, typically from land sales and shadow banking. The result is bank lending for expenditures that don't generate commercial returns and should have been funded all along out of the state budget. Such debt piles up and is eventually written off with other nonperforming loans.

Then there's the country's slowing growth. The problem isn't a lack of productive capacity to grow at 7 per cent a year; it's that a 7 per cent rate is unsustainable due to inadequate demand.

China can no longer rely on exports given Europe's continued malaise and America's relatively import-weak recovery. Chinese investment rates meanwhile will decline given lower returns and the need to deleverage.

Household consumption won't greatly increase because growth, having been exceptionally high for a decade, will decline as wage increases slow. To date, Beijing is pursuing selective stimulus policies that only heighten the ultimate need for deleveraging.

So how can China deal with its debt issue while also finding the demand to make up for weaker external markets and lackluster growth in investment and personal consumption? The answer lies in restructuring the current fiscal system -- and it appears a plan is already in the works.

China's budget is unusual in its limited size and in how it misaligns revenues and expenditures between the central government and the provinces. The total budget is only 28 per cent of gross domestic product (compared with 40 per cent to 45 per cent for the major OECD economies and more than 35 per cent for upper middle-income countries).

In June, Beijing promised to complete a detailed framework for a major fiscal overhaul within two years. The package aims to reduce local budget shortfalls by expanding the value-added tax (to include services) and instituting new taxes on natural resources and property. It also calls for restructuring local government debts (often into long-term bonds) and eliminating loans backed by land.

By introducing multiyear budgeting, the new approach could reduce incentives for collecting off-budget revenue to meet short-term fiscal targets. Local officials will be assessed partly on how they manage their debts.

A restructured fiscal system will relieve the pressure on commercial and shadow banks to fund infrastructure projects. More important, it will enable a more balanced structure of aggregate demand by reducing reliance on debt-fueled investments by state-owned enterprises and increasing the role of state budgetary expenditures.

This may sound sacrilegious to anyone who believes that only private-sector dynamism can cure economic ills, but China's state is unusually parsimonious in its social expenditures and has plenty of room to grow. As noted in the World Bank's “China 2030” report, Chinese social spending and transfers as a share of GDP are roughly half those of comparable middle-income economies and a third those of OECD countries.

With a stronger revenue base and a clearer mandate to fund social services, government consumption could increase to around 18 per cent of GDP by the end of the decade from 13 per cent today. That would offset significant investment declines and provide the demand needed for 7 per cent growth over the decade to come.

A byproduct of major fiscal reform would be greater public scrutiny of central and local budgets, as citizens would expect rising state expenditures to directly improve their living standards. This would create pressures for more meaningful participation of citizens in the National People's Congress and provincial assemblies, paving the way for more democratic decision making.

Commentary outside China has largely ignored Beijing's ambitious fiscal agenda, instead obsessing over small changes in interest and exchange rates. But given the current system, financial liberalisation will be less effective than fiscal reform in altering the behavior of economic and political actors.

Success, however, is far from assured. Some reforms already announced may be blocked by vested interests. More work on both strategy and tactics is needed before we can be confident that China has found the path to sustainable high-speed growth.

Yukon Huang is a senior associate at the Carnegie Endowment and a former World Bank Country Director for China.

This article was first published in the Wall Street Journal. Reproduced with permission.