Yukon HuangandJoshua Levy

China’s local government debt may not cause a financial crisis, but it poses a huge fiscal challenge

China must boost its tax rates and realign tax and expenditure responsibilities so local governments become less dependent on revenue allocations from Beijing and land sales to finance their expenditure

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A cockle farmer trudges through a muddy field near the Meizhou Bay bridge, which is under construction as part of the Fuzhou-Xiamen high-speed railway project, in Putain, Fujian province, China, on February 8. Local governments have poured funds raised by the floating of bonds into infrastructure projects. Photo: Bloomberg

Yukon HuangandJoshua Levy

Published: 3:30am, 28 May 2021Updated: 4:24am, 28 May 2021

Some months ago, panic was beginning to set in as Chinese bond defaults surged. Since then, investor nerves have steadied, but a crisis has not been totally averted. The defaults of state-owned enterprises (SOEs) and local government financing vehicles (LGFVs) are stories about debt. But the usual debt statistics conceal far deeper fiscal problems than the typical banking vulnerabilities in other economies.

On the face of it, China’s debt statistics offer a mixed picture in terms of risks. Household debt has risen steadily over the past decade to around 60 per cent of GDP, but this is comparable to other economies and driven by the emergence of a more prosperous middle class and a vibrant housing market. Government debt (central and local combined), at around 45 per cent of GDP, is only about half that of the United States.

The category that does raise concern is corporate debt, which at around 150 per cent of GDP is unusually high and largely driven by SOE borrowing. But these numbers are misleading – they include debt issued by LGFVs, which are classified as SOEs but differ from other state-owned companies in their activities.

This phenomenon is an outgrowth of China’s skewed fiscal structure. In China, provincial and municipal governments lack broad taxation powers; those are jealously guarded by Beijing.

Yet, the central government relies on its local counterparts to fund and provide the bulk of infrastructure and social services. So, provinces are chronically short of revenue but burdened with spending obligations.

For many local governments, establishing LGFVs allows them to spend beyond their restricted means. That debt is better categorised as government liabilities than corporate debt.

Local governments have poured the funds raised by the floating of bonds via LGFVs into infrastructure projects. In 2000, the levels of fixed asset investment undertaken by SOEs that were locally and centrally run were similar.