China has an increasingly murky debt problem, and it's partly due to this 25 year-old law

(VCG via Getty Images)
  • Research from NAB suggests the buildup of hidden debt at the local government level in China hasn’t been adequately addressed.
  • And NAB economist Gerard Burg said it is partly a function of budget laws introduced in 1994.
  • The rules effectively centralised tax revenue in Beijing, stripping local governments of their main revenue source and forcing them to look elsewhere for funding.

This year’s selloff in Chinese stocks has prompted a renewed pledge from top policymakers to ramp up stimulus efforts.

Analysts have pointed to tax cuts and infrastructure spending as two of the more practical options available to boost growth.

But due to excessive debt at the local government level, further infrastructure spending could be “problematic”, NAB economist Gerard Burg says.

And he attributed part of that debt buildup to budget laws passed back in 1994, which saw local governments lose their primary income source as tax revenues became centralised in Beijing.

The share of fiscal revenue received by local governments slumped to 44% in 1993, down from 78% the previous year.

As a result, they “were forced to generate alternative sources of funding to meet their expenditure requirements”, Burg said.

National Australia Bank

The laws also prevented them from issuing bonds or borrowing from state-owned banks. So instead they used Local Government Financing Vehicles (LGVFs) — entities which raised funds from smaller lenders and shadow banks.

How much of this hidden debt have local Chinese governments racked up? It’s hard to say. The data on government debt out of China is “at best opaque”, Burg says.

That’s partly because China’s National Audit Office hasn’t updated its estimates of local government debt since 2014. In 2013, non-reported debts were estimated to be around 7 trillion yuan ($US1 trillion).

Since then, restrictions were loosened on local government bond issuance which has provided another way for LG’s to raise funding. But Burg says the problems around hidden have merely been “overlooked, rather than effectively addressed”.

A report in March 2018 by the Chinese Academy of Social Sciences estimated that LGVF shadow debt has now reached 30 trillion yuan (around $US4.3 trillion).

And here it gets problematic is that large-scale infrastructure projects have a long-term time horizon for investment returns.

But that creates a “mismatch” with the short-term nature of most local government debt, including shadow banking products.

Having lost their ability to generate tax revenue, many local governments have relied on land sales for income — a model which Burg says isn’t sustainable.

National Australia Bank

Instead, “a key reform that would boost the sustainability of local government revenues would be the implementation of property taxes”, he said.

Such reforms have been “proposed for over a decade, but repeatedly delayed”.

The latest announcement pushed any property tax roll-out back to 2019, and an exact start date hasn’t yet been agreed to.

Whatever the exact number is for LGVF debt in China is, it’s most likely far higher than official numbers suggest.

And with such a degree of uncertainty, it “highlights the risks associated with infrastructure led stimulus to China’s economy”.

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