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Thursday, March 26, 2015, 09:44

Debt hangover to give nation the budget blues

By Zheng Yangpeng
Debt hangover to give nation the budget blues

An employee counts yuan banknotes at a bank in Huaibei, Anhui province June 22, 2010. (Photo / Agencies)

In the third in a series on the 'new normal' economy, Zheng Yangpeng reports on efforts to resolve local government finances.

The nation is pursuing a more proactive fiscal policy in 2015 to offset the economic slowdown. But for experts familiar with China's public finances, there is a worrying source of uncertainty - that of local governments' off-budget spending.

The target for the national budget deficit this year is 1.62 trillion yuan ($260 billion), which would be 270 billion yuan wider than last year's, according to the annual Government Work Report. This year's figure represents 2.3 percent of GDP, up from 2.1 percent last year.

Fiscal expenditures are a major factor in a country's economic performance, especially in China, which relies heavily on government-led investment. As many economists have pointed out, public spending matters in China for more than one reason.

First, there is its sheer scale, accounting for nearly 40 percent of fixed-asset investment. Second, it leads private investment. If public investment growth tumbles, private investment will not expand, either.

But the official budget is just part of the fiscal picture, and not the biggest one either. Provincial and city governments spend huge amounts on capital projects off-budget through government-related entities. The country's fiscal deficit would be much larger if this spending was included.

"The fiscal deficit set by the central government held at about 2 percent of GDP in the past three years. But in the same period, the growth of off-budget spending, classified as 'local government debt', was astonishing," said Zhu Haibin, chief economist in China at JPMorgan Chase & Co.

State auditors found that as of the end of June 2013, total liabilities of local governments stood at 17.9 trillion yuan, up from 10.7 trillion yuan at the end of 2010. That means local government debt grew at an annualized rate of 23 percent.

By comparison, budget spending in 2013 rose 10.1 percent.

Zhu estimated these debts alone would yield an annual fiscal deficit of 6 percent to 7 percent.

"These numbers demonstrate why even though China's fiscal deficit remained at a moderate level, GDP growth maintained high levels in the past few years," Zhu said.

In August, the central government intensified its curbs on local government borrowing, which might rein in off-budget spending this year. Economists agreed that regulating opaque borrowing through local government financing vehicles was an appropriate step.

Some worry, however, that a disruption in local government financing could trigger a "fiscal cliff". That phase came into circulation in 2012 in the United States, when many analysts warned that the combination of spending cuts and tax increases would trigger a recession.

The situation is not quite the same in China, because there are no tax hikes accompanying the effort to curb local debt and spending. But the fears of disruption are not groundless, either.

Steps taken last year underscored the central government's determination to tackle the thorny problem of local government debt, but observers are grappling with the implications of these moves.

In a landmark document issued on Oct 2, the State Council clarified for the first time that LGFVs can no longer raise funds for local authorities, and those local governments have no obligation to repay debt that was not raised to fund public projects.

A few days later, the Ministry of Finance issued a guideline on dealing with the outstanding debts. Local governments were ordered to classify their debts by Jan 5 into two categories: those that were to be included in their fiscal budgets and those that LGFVs were to resolve on their own.

"Outstanding local government debts will be cleaned up, reported and locked up. Once identified as government debts, they will be covered by the governments' budget management, repaid by corresponding budget income or gradually substituted by local government bonds," said Vincent Chan, an analyst with Credit Suisse.

Chan agreed that it is appropriate to defuse the risk of a debt crisis, but he said he was not sure how the nation could "ensure a smooth transition from current to new channels".

Li Yan, an analyst at China Chengxin International Credit Rating Co Ltd, said: "The current quota of local municipal bonds (400 billion yuan in 2014) is far from covering local governments' financing needs."

It is hard to imagine that the financing function of LGFVs can be covered with such one-off measures.

"There must be a transition period where the old system and new channels coexist," Li added.

The government envisions bridging that gap by issuing more municipal bonds and "special-purpose bonds", and inviting private capital to participate through public-private partnerships.

But those initiatives will take time to develop. Meanwhile, local governments need to repay debt from their fiscal revenue, which will constrain their expenditures. It is not quite a "fiscal cliff", but it could have a similar impact.

Analysts said that bolder initiatives are needed.

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