Fan Gang

Check borrowings by local govts

By Fan Gang (China Daily)
Updated: 2010-06-02 07:48

Imposing a ceiling on local government debt could prevent a Greek-style crisis from erupting on the mainland

While parts of the world are dealing with the aftermath of the financial crisis or an emerging sovereign-debt crisis, China is coping with the risk of overheating and/or an asset bubble.

Many factors may be pushing China's economy in this direction. One of the most worrying is the same factor that fueled the current crisis in the Eurozone - mushrooming public debt.

In the Eurozone, the problem is member countries' sovereign debt; in China, the problem is borrowing linked to local governments.

In the Eurozone, a bloated social-welfare system, particularly for the rapidly growing population of retirees, and the economic slowdown caused by the financial crisis are key components of the structural debt problem. In China, it has been caused due to increased borrowing by local officials in order to ensure that their regions' economic growth rates remain at double-digit levels.

There are, no surprise, commonalities between China and the Eurozone. Obviously, debt accumulates wherever people want to spend more than they have saved. But a more specific similarity is that highly indebted Eurozone countries and Chinese provinces and counties have been spending too much of a common currency.

Because these funds are not issued or controlled by any member country or local government, Eurozone members and Chinese local governments cannot relieve their debt problems through devaluation. So, in both cases, when a debt is defaulted upon or loans become non-performing, the negative consequences are felt by the entire financial and monetary "zone" - the entire EU and all of China. To avoid such an internal "sovereign debt crisis," China's Budget Law, adopted in 1994, forbade local governments from borrowing autonomously, either by issuing bonds to the public or by getting credit from banks. In theory, this means that local governments cannot finance their deficits by increasing their debt levels, because they can borrow only from the central government or other central authorities.

But the Budget Law did not put an end to the problem. While local governments have been unable to borrow, locally controlled state-investment companies can. So it is no surprise that a huge volume of bank loans has passed through the local branches of state-owned banks to finance local public-investment projects.

These borrowings caused a surge in non-performing bank loans in the early and mid-1990s, when total non-performing loans hit 40 percent of GDP. This caused a credit crunch and prolonged deflation in the late 1990s, as the central government tried to clean up the mess.

Due to privatization of State-owned enterprises and improved financial regulation, including bank supervision and risk control, since 2000 both central and local budgets have basically been in good order. The ratio of total public debt to GDP was less than 22 percent in 2007-2008, before the global financial crisis. There was still some borrowing by local governments, of course, but on a limited scale (totaling 3-4 percent of GDP), owing to institutionalized surveillance of lending.