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A Debt Dilemma: Reform or Crisis

May 27 , 2013
  • Zhang Monan

    Senior Fellow, China Int'l Economic Exchanges Center

The greatest risk in the present-day global economy is the continuous exacerbation of sovereign debt risks, which are haunting both developed countries and rising economies. China is no exception. Its government debts have recently caught the attention of the world, with experts and scholars coming forward one after another to argue that China’s debts have reached a dangerous level and spiraled out of control, and that China is doomed for a debt crisis.

Zhang Monan

No one can accurately assess China’s current debt situation, unless the judgment is based on a scrutiny of the country’s sovereign balance sheet and an examination of the transmission mechanism behind it. All developed countries now deeply mired in the sovereign debt crisis have been following the path of ”low growth, big deficits and high liabilities,” and have remained in the negative territory of net assets. China, however, has opted for the development model of ”high growth, small deficits and low liabilities.” Moreover, China has built up a mountain of positive net assets. Based on a wide caliber, for instance, China’s net assets stood at 69.6 trillion yuan in 2010. This means that China won’t fall into any debt crisis because it has enough sovereign assets to pay for its sovereign debts. China has also not come near to the international cordon in terms of financial deficits or debt ratio.

Needless to say, China has remained exposed to the risk of growing sovereign debts. The big financial stimulus package and the lenient credits it has handed out since the outbreak of the global financial crisis has raised the debt leverage of the Chinese government and, in particular, the local governments. Data has shown that by the end of 2011, the outstanding debts of the provincial, prefecture and county levels hit 10.7 trillion yuan, with the outstanding government debts of the institutions running financing platforms at 4.97 trillion yuan, or 46.38 per cent of the total local government debts. Of the 2856 county-level governments, only 54 were debt-free. Given the 7.2 trillion yuan of the central bond balance at the end of 2011, the total government debt stood at 18 trillion yuan, about 38 per cent of the country’s 2011 GDP. Nevertheless, the figure remained within control, and was much smaller than those in most developed economies. The risks here, however, do not lie in the size of China’s government debts. What is most worrying are the structural risks lurking behind them.

From a medium and long-term point of view, covert debts pose the biggest risks for China. A complete covert guarantee system has taken shape, with the central government standing at the center and local governments making up the dominating links. As a matter of fact, all local treasuries keep considerable power over financing, and do not subject themselves to budget constraint. Deviating from the line marked in the Budget Law for balancing their financial revenues and expenditures, most of them choose to raise a lot of debt. As a result, they have fallen deep into non-overt debts consisting of arrearages, credits and guarantees. Due to lack of any definite division of their debt repayment responsibilities, however, the local governments would pass over their responsibilities to those at a higher level once their debts grow out of their financial capacities, endangering central financial security.

Local government debt risks have continued exacerbating along with the acceleration of the pace of urbanization. Since their incomes from land transfers and tax revenues are hardly enough for the launch of urbanization undertakings, the local governments create all forms of investment and financing platforms such as urban development companies, local commercial banks and urban investment companies to raise funds from the society and banks.

With weaker growth in their nominal GDP and a fast slowdown of their tax revenues and land-transferring fees, the local governments are seeing their land-related incomes falling daily. In 2012, their land-transferring fees accounted for merely 27 per cent of their financial revenues and only 5.9 per cent of their net incomes. Even when their land-related tax revenues were brought in, the land-related net incomes earned by the local governments in 2012 just made up 20 per cent of their financial revenues in the year, 31.7 per cent lower than the peak level attained in 2010. Although local government debt risks have not yet spiraled out of control, the slowdown of the growth of the national economy as a whole is driving local government debts to an even higher level. Since the Chinese government no longer boasts a financial surplus and a low debt ratio as it did before the outbreak of the global financial crisis, it does not hold a solid position against the risks from the rapid growth of government debts, especially when the economy falls at a fast pace. It also can no longer grow its balance sheet based mainly on land finance any longer.

It is obvious, therefore, that the debt risks endangering both the central and the local governments are rooted in the country’s financial system. As the situation stands, it is necessary to speed up reforms of both the central and the local financial systems and substantially increase the financial and debt transparency. Given the fact that repayment of local government debts has entered a peak period since 2012, a financial risk reserve may be created as a makeshift. To keep growing year by year, this general reserve fund may be used exclusively for repayment of overdue government debts. This may be the most effective system arrangement for preventing the spread and transfer of debt risks.

From a medium and long-term point of view, a race between reform and crisis will be inevitable. China must perfect its central and local financial systems, and create a framework for the control of financial debt risks at the earliest date possible. On the one hand, greater efforts should be devoted to the control of local government debts by putting into place a budget-regulated debt financing mechanism, so that the debt level of local governments will be kept at a rational level. On the other hand, the slowdown of the growth of the Chinese economy and the contraction of land-related revenues will put an ever greater debt repayment pressure on the local governments. As the situation stands, it is necessary to cope with the debt risks in two ways: to prevent and to lighten them. It admits of no delay of a rational division of financial powers and authority of office between the central and the local governments, and a reform of the country’s financial and tax systems that centers on the affixation of responsibilities over spending.

Zhang Monan is the Deputy Director and Associate Research Fellow of World Economy Study at the Economic Forecast Department of the State Information Center.

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