China’s national problems start in local government; Appeals for financial restraint and prudent investment have failed

May 19, 2013 6:32 pm

China’s national problems start in local government

By George Magnus

Appeals for financial restraint and prudent investment have failed, writes George Magnus

The structural slowdown in China’s economy is starting to cause waves in Beijing, prompting trenchant questions about what the government should do about it. Premier Li Keqiang has recently played down the expectation that there is much the government could or should do, saying that China must rely more on “market mechanisms”. This is, in effect, an acknowledgment of a contradiction in China’s economic model.

Local governments and state enterprises, pillars of that model and its investment-driven growth, have become the agents of both the downswing in growth and increased concerns about financial risk. Fixing this problem, as Mr Li suggested, would be transformational, if the party can do it. Driven by vigorous internal competition and a considerable degree of political autonomy, local governments play a pivotal role in promoting local economic, investment and political interests, and delivering economic growth. Despite strong demands for greater provision of public services, local officials are incentivised by reward and patronage to focus on gross domestic product. Local government spending, however, is having less traction with the economy.Local government borrowing has tripled since 2007, doubling as a share of GDP to about 30 per cent. Their finances have been weakened by rising social spending, faltering revenues from land sales, diminishing or negative returns on their investments and deteriorating cash flows. They are having to borrow more to refinance maturing debt, service existing debt and replenish working capital. Many wonder if Chinese local governments might be the next “subprime”.

Weakly regulated and over-indebted local governments are not unique to China today. In the US, reckless municipal financing left strong fingerprints on three 19th-century instances of financial ruin – 1837-43, 1873-79 and 1893-99. Municipal spending expanded to become the biggest source of public spending and, by 1900, state and local government debt rivalled that of the federal government. Urbanisation, as in China today, was a prime driver but the reason for the expansion of spending was a strong revenue base, courtesy of property taxes. By contrast, Chinese local governments have a weak revenue structure and widespread property ownership taxation is close to a political taboo.

US states responded to episodes of financial stress and over-issuance of municipal debt by limiting or preventing public investment in private companies and capping debt issuance. In the 1930s, Washington took control over the fiscal system, placing income and payroll taxes at its heart, and implementing a system of grants to state governments, which administered the proceeds with local governments. Over time, the US subordinated its local governments to Washington, and built a strong legal financing framework that allowed the municipal finance market to evolve in an orderly fashion and for individuals to supplant institutions as the largest group of investors.

China, however, has yet to favour, let alone develop, such a legalistic approach. Appeals from Beijing for financial restraint and more prudent investment behaviour have not been enforced rigorously and the local government debt problem has increased. Barred from raising money directly in banking and capital markets, they have set up thousands of “local government financing vehicles” since 2008. These entities have been leading drivers, moreover, of the eruption in China’s shadow banking system. To some Chinese commentators, they represent a new breed of state enterprises that monopolise financial resources, distort markets and crowd out private investment – precisely the risks to economic growth to which Mr Li alluded.

Local governments typify the broader issue the government faces in wanting to promote market mechanisms. This means changing the balance between state-directed growth and private sector competition and innovation. Mr Li wants the central government to consolidate its authority and local officials to respect its orders and policies without hesitation.

This would transform government. Central government would assert its authority over fundamental economic goals, such as lower sustainable growth, environmentally friendly expansion, fiscal reform and lower income inequality. Local governments would switch focus from chasing growth to the provision of public goods and services.

Mr Li is also well aware that this would involve tackling vested political and party interests, a task he has described as harder than “stirring the soul”. But to underpin stable and sustainable growth, China has to turn away from the cosseted credit- and investment-centric growth model, in which local governments and state enterprises figure prominently, to reform the political and institutional framework in which resources are allocated, economic decisions are made and innovation occurs. As ever, the issue in China is not intent but implementation.