Commentary: China’s debt divide is hurting its economy

PRESSURE ON LOCAL GOVERNMENTS

A basic fact about China’s fiscal system is that local governments do almost all of the spending, but rely on the centre for revenue to an extent that is rare elsewhere in the world.

Localities bear most of the responsibility for education, health, social security and housing, in addition to obvious local duties such as roads, parks and rubbish collection, and spend about 85 per cent of the government total. They directly collect only around 55 per cent of government revenues. The system is balanced by transfers from the centre to the regions.

In a country as large as China there are merits to devolving decisions closer to the people, but the mismatch between revenue and expenditure creates many problems. For example, the lower down the pyramid of governance, the more the system gets starved of resources, because each tier – province, prefecture, county – tends to hold back what it needs before passing cash onwards down the chain. The implementation of central government spending plans is haphazard.

Meanwhile, local government officials, who must deliver growth to climb the bureaucratic ranks, do whatever they can to find money.

China’s property boom was partly driven by the reliance of local governments on land sales for revenue. Off-the-books borrowing by so-called local government financing vehicles was a way to get around the revenue constraint and fund infrastructure.

As land sales slump due to the housing slowdown, and the central government cracks down on local borrowing, there are many reports of municipalities resorting to fines and penalties, launching retrospective tax investigations or simply not paying staff on time as they struggle to balance their books. None of this is good for the struggling private sector.

Beijing knows all about these structural problems and has long aspired to fix them. Indeed, when Xi Jinping first came to power in 2012, fiscal reform was a big part of his domestic policy agenda, elements of which he delivered. Part of the reason why local governments are struggling, for example, is the success of reforms to budgetary management and financial administration, which made it harder to paper over problems by shifting them off the books.

What the central government has not been willing to do, as is typical for Xi, is surrender control. It often specifies the services that local governments must provide, yet declines to hand over the revenue sources that fund them. It is reluctant to take big new spending responsibilities onto the central books.

It has cracked down on local government debt, and yet true to Zhou’s preferences, it is unwilling to let central government debt rise instead. The result has been a de facto fiscal tightening during the past few years even as the economy has struggled to recover after COVID-19.