Since the 1980s, China's central government has struggled to manage local government finances. The problem has been exacerbated by the creation of local investment firms that borrow from banks to lend money to local governments. Beijing has allowed the system to operate knowing that it boosts development in the provinces and is helping them endure the economic downturn. But after a surge in spending during the recession, Beijing has grown more fearful about local governments' off-budget debt and is moving to reassert control.
On March 5, China's Ministry of Finance announced it is planning to ban all future guarantees provided by local governments for loans they receive from local investment firms and that new rules will be drafted to control local-government spending. This followed a Feb. 26 announcement by China's banking regulatory commission that commercial banks must stop lending to local investment firms. With 40 percent of China's record 9.6 trillion yuan (about $1.4 trillion) in new-loan growth going to local governments in 2009 — and with increasing public debt and credit risk — banking regulators are concerned about the ability of local governments to borrow without central government oversight. For the past three decades, Beijing has struggled to gain control over local-government spending. In the 1980s, China's tax system was decentralized, which gave local governments more control over tax collection and spending. But it also caused a rising central-government deficit and limited Beijing's ability to control inflation by reducing fiscal expenditures. In 1988, amid rising social instability caused by inflation, the central government launched its first attempt to centralize the tax system. It did so by implementing a fiscal contracting system, in which the central government would share tax revenues with local governments by keeping a fixed quota plus a negotiated percentage share for itself. However, local governments exploited this system by reducing on-budget tax revenue in favor of off-budget tax revenue that they did not have to share with the central government. This led to a rising budget deficit for the central government as revenues from the localities fell. In 1994, the central government reformed the tax system once again, this time successfully simplifying the tax structure and assuming direct control over local-government revenues. Crucially, these reforms made it illegal for local governments to incur budget deficits and issue their own debt. But China's centralized tax system has created problems for local governments attempting to finance their activities. With 75 percent of revenue from the major taxes (value-added, income, sales and consumption) going to the central government, provincial governments rely on central government transfers and subsidies to finance their official spending. But between 1994 and 2007, the central government surplus was less than local government deficits, indicating an average yearly local-government budget deficit of at least 1 percent of national gross domestic product (GDP). Moreover, these transfers reduce the freedom of local governments to direct their own spending. The central government uses the transfers to encourage localities to spend money on central government-approved projects. (click here to enlarge image) Hence, local governments resort to borrowing money from banks to finance their projects — whether officially sanctioned or not. China's Ministry of Finance estimates that 80 percent of the outstanding debt held by local governments — totaling 6 trillion yuan (about $882 billion) — is in bank loans, which amounted to about 16.5 percent of China's GDP in 2009. China's banking sector is still heavily influenced by the state — commercial banks lend money to local government infrastructure projects, real estate developers and favored local firms. According to estimates from China's Ministry of Finance, local governments have established more than 4,000 investment firms nationwide to borrow money from banks. These firms are deemed safe investments for foreign and domestic lenders because they are government entities implicitly backed by the central government. Local governments are able to continue borrowing from banks as long as they can pay down the interest with revenue, a good portion of which comes from land-transfer fees. Local governments control land allocation and exact a fee from developers when they buy or sell land. In 2009, provincial governments gained a record 1.59 trillion yuan (about $233 billion) in revenue from land sales, up 60 percent from 2008. Aside from giving local governments an incentive to encourage real estate speculation, this money also allows local government-operated investment firms to pay down the interest on bank loans. Needless to say, Beijing has enormous reservations about having 31 provincial governments using a variety of independent investment vehicles to rack up off-budget debt. Beijing has allowed the system to operate knowing that it boosts development in the provinces and enables provincial governments to survive the current period of economic hardship. But after the huge extensions of credit in 2009 to combat the economic downturn, China has become more fearful of the hidden risks associated with the often excessive, opaque and risky local-government borrowing (a separate concern from the often excessive, opaque and risky lending policies dictated by the central government itself). In order to compensate, the central government has said it will develop a municipal bond market — controlled by the Ministry of Finance— to help wean local governments from bank borrowing. In 2009, the ministry launched a trial program to issue a total of 200 billion yuan (about $29 billion) in municipal bonds, and Premier Wen Jiabao has pledged to continue the trial by allowing another 200 billion yuan in debt to be issued in 2010. However, this accounts for only 3 percent of the official local-government debt that was accumulated as of 2009 and less than 5 percent of the bank loans issued to local governments in 2009. Controlling local-government borrowing is especially important to slow down the growth of asset-price bubbles. Local governments helped inflate these bubbles in 2009 by encouraging banks to lend to real estate developers and to profit from land sales. Yet as the central government attempts to rein in local government spending, it must be careful. Collapses in real estate markets or a growing number of unfinished infrastructure projects would pose a significant threat to local government budgets and the banking system. In 1998, China's second largest financial trust, Guangdong International Trust & Investment Corp., collapsed and refused to pay back loans to foreign lenders. While the central government may have the ability to bail out large domestic banks, foreign lenders and informal domestic bank lenders would be vulnerable. A wave of local-government bailouts would come at a significant cost to overall stability.