In the coming years, China’s government will have to confront significant challenges to achieve stable, inclusive, and sustainable economic growth. But, with mounting fiscal and financial risks threatening to derail its efforts, policymakers must act quickly to design and implement prudent, forward-looking policies.
Zhang Monan
The most significant medium- and long-term threat to China’s fiscal position lies in the system of implicit guarantees that the central government has established for local-government debt. In the wake of the global financial crisis, local governments borrowed heavily from banks to support China’s massive stimulus program, amassing ¥10.7 trillion ($1.7 trillion) worth of debt by 2011.
China’s leaders hope to control potential risks stemming from local-government investment vehicles (LGIVs) by limiting bank lending. The balance of bank loans to LGIVs increased only slightly in 2012, to ¥9.3 trillion, from ¥9.1 trillion in 2011. And the China Banking Regulatory Commission has called on banks to retain last year’s LGIV loan quotas for 2013, and to ensure that the overall balance of loans to LGIVs does not exceed the 2011 year-end total.
But LGIVs obtained a massive amount of financing in 2012 by issuing bonds and trust loans. This includes ¥250 billion in local-government bonds, ¥636.8 billion in urban-investment bonds, and technical cooperation trust-fund projects totaling ¥501.6 billion, representing year-on-year increases of ¥50 billion, ¥380.6 billion, and ¥247.9 billion, respectively.
Even with these funds, however, local governments have struggled to make ends meet. Tax reforms implemented in 1994 caused local governments’ share of national fiscal revenue to decline steadily, from 78% in 1993 to 52% in 2011. Over the same period, however, their share of total government expenditure increased from 72% to 85%.
The need to fill the resulting gap has forced local governments to depend on land sales. But land-related income has plummeted over the last two years, from 32% of total revenue in 2010 to 20% last year. Measures mandated by the central government to control surging real-estate prices will continue to reinforce this trend, increasing pressure on local-government revenues.
The risk stemming from local-government debt is exacerbated further by massive amounts of non-explicit debt acquired through arrears, credits, and guarantees. When a local government is no longer able to service its debt, the central government will have to place its own fiscal capacity at risk by assuming the responsibility.
China’s financial stability is also under threat, as lenders turn to unofficial channels to circumvent tighter government regulations on the formal banking system. Perhaps the biggest risks stem from China’s rapidly growing shadow banking system.
Shadow banking can be conducted through trust loans (extended by trust companies), entrusted loans (company-to-company credits brokered by financial institutions), bank acceptances (company-issued drafts or bills that are endorsed by banks), and corporate bonds (debt securities issued by companies directly to investors). These instruments’ combined worth reached ¥5.9 trillion last year, led by corporate bonds (¥2.3 trillion).
New lending by trust companies – which rose by more than 400% last year – is generating significant solvency risk in China, given that it is frequently extended to higher-risk entities, including real-estate developers and LGIVs. A spike in defaults could destabilize the entire financial system and trigger an economic downturn. And trust loans tied to LGIVs ultimately enjoy the same implicit guarantee from the central government as official bank loans.
Regular banks, too, are trying to evade new regulations by ramping up off-balance-sheet lending. Indeed, it is increasingly common for banks’ off-balance-sheet lending to exceed newly issued balance-sheet credit. In 2011-2012, such lending grew by ¥1.1 trillion, reaching ¥3.6 trillion (23% of total bank financing), while balance-sheet lending increased by only ¥732 billion.
But the former is usually implicit and uncertain, making it vulnerable to default. If faced with such losses, banks might choose to protect their reputations by using official funds for repayment, transferring the risk onto their balance sheets.
More generally, the rapid expansion of credit risks increasing inflationary pressure and fueling the formation of asset bubbles. Conversely, when the monetary authority tightens credit too quickly, asset prices become more volatile, resulting in more non-performing loans and triggering economic shocks.
China’s government must implement prudent macroeconomic policies now to minimize escalation of these risks later. Medium- and long-term fiscal stability will require policies that account for the growing disparity between fiscal revenues, which are suffering from slowing GDP growth, and expenditures, which will be driven up by structural tax cuts and increased social-welfare spending.
In order to manage growing pressure on public finances, China must establish highly efficient public-budget and fiscal-restraint systems. To this end, the government must tighten financial supervision, improve budgetary management, and enhance the operational efficiency of fiscal policies.
China also needs a new financing model for infrastructure projects. The current system relies heavily on LGIV loans and fiscal expenditures. But local governments cannot continue to rely on revenue from land sales to repay their debts or support current spending. More stable financing channels and stronger enforcement of operating standards are essential to support rapid urbanization.
As prudent fiscal and financial policies gradually stabilize China’s economy, monetary policy must remain neutral. Loosening monetary policy would increase significantly the risks stemming from local-government debt and shadow banking, while tightening monetary policy would fully expose those risks, posing a serious systemic threat.
With the right balance of vision and caution, China’s leaders can tackle the buildup of fiscal and financial risk. If they fail to act decisively, China’s leadership of the future global economy will hang in the balance.
Zhang Monan is a fellow of the China Information Center, a fellow of the China Foundation for International Studies, and a researcher at the China Macroeconomic Research Platform.
© Project Syndicate 1995–2013
