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The Future of Fiscal Federalism in China

 
 

Having pledged to control macro debt in three years while slowing growth down, the Chinese government is increasingly driving home its deleveraging message. As the government seeks to cope with the political football of local debts, the dynamics of the Chinese apparatus this year will shape the country’s prospects for fiscal federalism.

Fiscal federalism emerged in 2014 responding to soft budget constraints on local governments. While enabling the mobilization of financial means to achieve growth targets beyond fiscal capacity, the government’s strong control over financial institutions also blurs financial and fiscal boundaries. At the local level, high pressure to achieve growth (and thus ensure a promotion) have led local officials to borrow off the books or resort to land sales to raise revenue, resulting in debt piles in the financial system.

The current administration has corrected some past wrongs while improving local finances, a shift sometimes described as “closing the back door while opening the front.” By lifting a 20-year ban on local government deficits, the revised Budget Law, effective from 2015, legalizes local borrowing and puts it under central scrutiny. In addition to improving local fiscal accountability, more significantly, the new law sets local finance on the track of fiscal federalism, where local authorities will take ultimate responsibility for their expenditures.

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In transferring off-balance sheet debts back to balance sheet, the ongoing local government debt swaps also reduce local financial costs by replacing credit with cheaper bonds. After four years in operation, the finance ministry announced in January 2018 the outstanding debts of 10.9 trillion yuan ($1.73 trillion) have been replaced, with another 1.73 trillion yuan ($274.63 billion) to finish by August 2018. Local governments are also issuing bonds to finance new projects, accumulating a total of 16.47 trillion yuan ($2.63 trillion) in debt by 2017.

Additionally, the government is developing more sustainable local taxes while reforming the tax-sharing system. An annual property tax for example, has been proposed to help wean local authorities off land finance. The consumption tax, currently levied by the central government, is in line to become a shared or local-only tax. The resources tax is still small but expected to grow; it brought 42.3 percent more revenue to local coffers in 2017 after a national move in 2016.

The central government is not only granting local authorities more financial means. It also is attempting to reduce local spending by redistributing local and central fiscal obligations. Categorizing spending items as local only, central only, and joint, the state aims to match local responsibility with fiscal capacity. Although recategorizing makes stronger sense in theory than in practice, progress is being made. The government in February 2018 released a second policy recognizing a range of joint expenditures in public services, following the release of a framework policy with a timetable in 2016.

As the government shifts its priority from growth speed to quality, there’s more room for changes. Now that they are being held accountable for local debts beyond the end of their tenures, local officials are increasingly curbed from engaging in financial irregularities. As the government updates local official performance evaluations correspondingly, the shift in incentives will further promote financial prudence.

The biggest challenge to fiscal federalism comes from local government financing vehicles (LGFVs). The very symbol of China’s financial and fiscal distortion, LGFVs channel funds from financial markets to local projects. Since starting a cleanup of LGFVs in 2014, the government has been cracking down on them ever since. Denouncing their public entity status, the government ordered LGFVs to commercialize and distance themselves from local authorities. Financial institutions are also being told to think twice about taking part, with a warning that the state will not honor any debts occurring on LGFVs. Despite these efforts, LGFVs are still found funding local projects in various ways.

2018 will be a critical year for LGFVs. On the one hand, the aggressive financial deleveraging drive has increased their costs, squeezing their space. Observers noted that coupon rates on LGFV debt grew by two percentage points from late 2016 to mid-2017. Looking at another proxy indicator – the annual rate of return of trust funds, which was 7.01 percent in June 2017 — their financial costs could be higher. On the other hand, the prevailing assumption is still that the local governments behind these vehicles will repay their debts. If the central government is truly resolved to end the practice, it may attempt to make an example out of some, increasing the chance for one or more LGFVs to default.

Finally, fiscal federalism assumes that local — not central — authorities control local finances. Local officials thus should issue bonds when needed and claim bankruptcy if it becomes inevitable. However, the central government, worried about careless local borrowing, is managing local debt by setting annual deficit ceilings. Despite the debate in 2014 on local government bankruptcy, the revised Budget Law falls short of addressing the issue.

Still, as the government strives toward rule-based governance, including in the fiscal domain, the push to draw clearer lines between China’s financial and fiscal system could intensify in 2018, eventually leading to increased local fiscal autonomy.

Xinling Wang is a Beijing-based analyst, writing on China’s macroeconomic policy.

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