Need to Know . . .
- The overall public debt, including off-budget liabilities for local governments, was estimated to be between 45% and 70% of GDP in 2012
- More than half of the debt was due within three years, and the distribution of local government debt was uneven, with some local governments particularly overstretched. The rapid development of local government debt could also entail substantial risks for banks
- Although much higher than suggested by the headline official government data, China’s overall public debt level as a percentage of GDP is still in line with other major developing countries and much lower than major developed countries
The rapid increase of China’s local government debt over the past several years has received considerable attention, and the prevention of further buildup of associated risks was identified by the central government as one of the six key economic priorities in 2014. Although the overall scale of the debt is large and debt repayment pressures are substantial, the situation is still at a manageable level and will not likely pose immediate threats to the country’s financial system and economic growth.
Under the current fiscal system, which was put in place in 1994, China’s local governments are requested to return a large share of their tax revenue to the central government, getting less than half of total fiscal revenue on average over the past decade. They are still responsible for many local needs, including infrastructure investment and maintenance, public service delivery, and social welfare spending, which together account for an average of 75% of total fiscal expenditures (Figure 1). During normal times, this mismatch between revenue and expenditures for local governments can largely be met by central government transfers and extra revenue sources, dominated by land sales.
Figure 1 – China’s Local Government On-Budget Revenue and Expenditures
Source(s): China Statistical Yearbook 2013
The mismatch has intensified since the global financial crisis in 2008, however, when the central government introduced a RMB 4 trillion fiscal stimulus package to shield the domestic economy from external shocks. The central government contributed less than one-third of the funding, with the rest of the package funded by local governments.
Given the increased fiscal pressure and the budget law’s prohibition against direct market borrowing, local governments have relied extensively on off-budget mechanisms to finance construction of public projects such as affordable housing and infrastructure development. More specifically, they set up companies and provide capital to them through budget revenue injection and transfer of land use rights and existing assets (such as roads and bridges) in order to meet capital requirements. These companies, often referred to as local government financing vehicles (LGFVs), are treated as municipal state-owned enterprises under China’s company law and essentially act as principal financing agents for local governments by channeling funding from the financial market, mostly banks, for infrastructure and real estate investment.
Risks and Vulnerabilities
The overall scale of local government debt is large and debt repayment pressures are substantial. According to China’s National Audit Office (NAO), which conducted the first national survey of local government debt in 2011, the stock of local government debt reached RMB 10.7 trillion as of the end of 2010, equivalent to about 27% of China’s GDP.1 This is broadly in line with estimates from other private sources that range between 25% and 35% of GDP.2
More than half of the debt was due within three years; local government fiscal revenue combined with transfers from the central government amounted to only RMB 7.3 trillion in 2010, however. Debt issued by LGFVs alone reached RMB 4.97 trillion, accounting for 45% of total local government debt. Since LGFVs mainly engage in large projects with long maturities, it is quite common for them to not have enough revenue sources and thus require support from local governments for debt repayment. Indeed, local governments were directly responsible for 62% of LGFVs’ debt. Even for the RMB 1.8 trillion contingent liabilities, local governments would likely be ultimately responsible since their fiscal position is often included as one important criterion by financial institutions to assess the creditworthiness of LGFVs.
In the analysis, the distribution of local government debt was uneven, with some local governments particularly overstretched. The NAO reported that 3 provincial governments, 99 cities, 195 county-level administrations, and 3,465 townships had direct debts exceeding 100% of their annual economic output. For some provinces, the debt burden associated with LGFV loans was several times lrger than their total 2010 revenue, including transfers from the central government.3
The rapid development of local government debt could entail substantial risks for banks, which were the biggest creditors for local governments, providing three-quarters of their direct debt and 85% of their contingent liabilities. Banks do not have easy access to local governments’ overall fiscal positions, however, and this lack of transparency prevents them from properly pricing credit risks.
In addition, as local governments rely mainly on receipts from sales of land use rights for debt repayment, banks would be vulnerable to a sharp correction in real estate prices, and the potential impacts of asset quality deterioration on banks’ balance sheets are not negligible. According to a recent report from the IMF, if 35% of the RMB 1.6 trillion loans to the LGFVs became bad, the four state-owned banks would see their non-performing loan ratios jump from 1.3-2.2% to 2.9-4.6% in 2011.4
Concerned about the rapid rise of local government debt, authorities started to take actions in 2010 to strengthen the supervision of bank lending activities to LGFVs and prohibit local governments from guaranteeing LGFVs’ debts. Local government debt has continued to outpace China’s GDP growth over the past three years, however, and grew 67% by June 2013, reaching RMB 17.9 trillion (Figure 2).5 The structure of the local government debt has not shown much improvement, with the share of debt maturing within three years rising and LGFVs continuing to be the dominant debt issuers. Although the share of bank lending fell from 79% in 2010 to 56%, some of the change was a result of an increase in indirect borrowing from financial institutions via shadow banking activities, making it difficult for regulators to monitor and control associated risks.6
Figure 2 – China’s Local Government Debt by Category
Source(s): China’s National Audit Office
Despite the failure to contain the fast expansion of local government debt, China’s fiscal position is not yet an acute concern. The overall public debt, including off-budget liabilities for local governments, was estimated to be between 45% and 70% of GDP in 2012 by various institutions. Although this is much higher than suggested by the headline official government data (32%), it is still in line with other major developing countries and much lower than major developed countries, including the U.S. (Figure 3). The liabilities are denominated mostly in China’s own currency and held domestically by state-owned financial institutions. Hopefully, the still manageable status of the public debt will give the government sufficient time to implement the much-needed fiscal reform outlined in the third plenum to prevent further risk building.7
Figure 3 – Overall Government Debt by Country, 2012
*Includes estimates of off-budget liabilities for local governments from the NAO
Source(s): OECD and World Bank and MAPI calculations
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- 1. National Audit Office of the People’s Republic of China, www.audit.gov.cn/n1992130/n1992150/n1992500/2752208.html.
- 2. Yuanyan Sophia Zhang and Steven Barnett, Fiscal Vulnerabilities and Risks from Local Government Finance in China, IMF Working Paper 14/4, January 2014.
- 3. Yinqiu Lu and Tao Sun, Local Government Financing Platforms in China: A Fortune or Misfortune?, IMF Working Paper 13/243, October 2013.
- 4. IMF Working Paper 13/243.
- 5. National Audit Office of the People’s Republic of China, www.audit.gov.cn/n1992130/n1992150/n1992500/3432077.html.
- 6. For more information, see Yingying Xu, China’s Shadow Banking Puzzle, E-712, MAPI, September 30, 2013.
- 7. For detailed discussion about the fiscal reform proposals, see Yingying Xu, China’s Economic Reform Proposals Have Strategic Implications for Multinationals, PA-133, MAPI, February 10, 2014.