Fan Gang

Check borrowings by local govts

By Fan Gang (China Daily)
Updated: 2010-06-02 07:48
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Then came the financial crisis, with the central government adopting fiscal stimulus and relaxing monetary policy. Local governments were encouraged to increase their spending on public infrastructure projects in order to maintain growth. As a result, the volume of bank credit financing local investments increased six-fold in 2009 alone. Indeed, total borrowing by local governments now amounts to roughly $900 billion, up from $150 billion year on year and the equivalent of almost 20 percent of GDP.

This level of borrowing poses a new type of financial risk for China. But how big and dangerous is that risk?

I believe that it remains manageable. Some local borrowing can be justified by the central budgetary allocation to local projects. Moreover, some local spending took place in regions that will continue to enjoy high growth in tax revenues for the foreseeable future, thus ensuring that the debts will be serviced. Perhaps only one-third of the total volume of loans is problematic; the rest may or will continue to perform.

The most important change that may keep the problem manageable is that China's monetary authorities have applied the brakes on the growth of these kinds of debt since late last year. In general, local borrowing windows are closed, and inspections are underway to gain an accurate picture of the situation. With economic growth continuing, the potential risk posed by this debt will diminish.

Chinese officials are drawing lessons from this heavy debt burden, as they fear the prospect of local governments creating an internal "Greek crisis" for the rest of the country. The authorities recognize the need for strict fiscal discipline and financial regulation. The leverage of any public entity must be monitored, supervised, and restricted.

Of course, Chinese local governments have never had total financial or fiscal autonomy. Indeed, ever since the Qin Dynasty (221-206 BC) united the country and established a centralized regime some 2,000 years ago, accountability for debt has been treated as a central government problem. Those who advocate fiscal decentralization and deregulation in China should think about establishing real local fiscal accountability first.

China's current legal framework contributed to fiscal balance and financial stability in the past, and it continues to play a positive role. Otherwise, China might already have experienced its own localized "sovereign debt" crisis and, perhaps, hyperinflation.

But when local governments are barred from debt finance, they look for other means. For example, they try to squeeze as much as possible out of land sales, thereby pushing up housing prices and helping to inflate asset bubbles.

Given the negative consequences of this approach, it might be wise for the central government to consider establishing, for the short-run, quotas or ceilings for total local government borrowing. But, in the long run, China's fiscal and financial stability will be ensured only by systematic institutional reform of central-local government relationships.

The author is professor of Economics at Peking University and the Chinese Academy of Social Sciences.

(China Daily 06/02/2010 page8)

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