Long overshadowed by numbers on economic growth, foreign investment and trade, government revenues have taken center stage

The state of China's government finances do not normally grab the headlines amid the economic data emanating from the world's second-largest economy.

Far more attention is paid to GDP growth with often small percentage adjustments in that they have a significant impact on global financial markets.

At the annual two sessions meeting of the National People's Congress and the Chinese People's Political Consultative Conference, which began in Beijing on March 3, the country's fiscal position has been one of the major talking points.

It was highlighted earlier this year in a report by Deutsche Bank, which forecast that total government revenue growth at just 1 percent would be the slowest since 1981. It also forecast that local government revenues would fall by 2 percent.

There was much interest therefore in Premier Li Keqiang's announcement of a 2.3 percent fiscal deficit target for this year as he unveiled the Government Work Report on March 5.

This was an increase on the 2.1 percent in 2014 and substantially above the 0.6 percent in 2008 before China's 4 trillion yuan ($639 billion; 563 billion euros) stimulus to give the economy a lifeline in the wake of the financial crisis.

China's fiscal issue has been brewing since a National Audit Office report published in 2011 revealed local government debt of 10.7 trillion yuan. By the end of June, 2013 this had risen to 17.9 trillion yuan, according to a further NAO report.

This led some to conclude the Chinese economy was heading toward a Lehman Brothers moment.

The economy's overall debt as a percentage of GDP increased 150 percent in 2008 to about 250 percent when government, corporate and household debt are taken into account. The government debt component was 55 percent of GDP in 2013, according to National Audit Office figures.

Charlene Chu, a former Fitch ratings analyst and now a partner in Autonomous Research Asia, warned in an interview with Bloomberg TV in January that China had "the biggest debt bubble that the world has ever seen" and was heading toward a Japan-style deflationary crisis.

Unusual, however, for a developing country, China does retain the capacity to absorb high levels of debt.

It has easily the world's largest foreign exchange reserves of some $4 trillion, four times more than Japan, which has the next biggest. Its leviathan state-owned enterprises also had assets of 104.1 trillion yuan in 2013, considerably more than the 53.3 trillion they held in 2009, according to China's Ministry of Finance.

Why China's fiscal position is suddenly turning from a headache to a migraine is due to a sudden collapse in the central plank of local government funding.

Unlike in many Western countries, China's local government spending is not financed in large part by local taxation.

It is heavily dependent, in fact, on the sale of land, mainly through local government financing vehicles, or LGFVs, which make up more than a third of income.

The recent Deutsche Bank report predicts that land sales revenue will slump 20 percent in 2015.

It comes at a time when the central government is also trying to reform local government financing by allowing municipalities to issue local bonds. Any new system is unlikely to be in place to alleviate the immediate shortfall.

Zhiwei Zhang, chief China economist of Deutsche Bank, says China's fiscal position is the single biggest problem for the economy.

"We believe this is the most important risk to the economy and one that is not well recognized in the market," he told Economic Times recently.

Many other China financial experts also see it as something that has come out of the blue.

In Shanghai, Gary Liu, deputy director of CEIBS Lujiazui International Finance Research Center and an expert on China's financial system, says: "The fiscal revenue slowdown is, indeed, surprising because over the last decade we have seen fiscal revenue growing much faster than GDP, and this is a significant change."

In the Canary Wharf, London office of the Economist Intelligence Unit, Duncan Innes-Ker, the research group's Asia regional editor, believes what we are now witnessing is something fundamental.

"It reflects the fact the government revenue model that has stood China in very good stead over the last two decades is basically coming to the end of its usefulness.

"Land sales have been a huge benefit to the Chinese government and they have to a certain extent allowed the supercharged growth we have seen in the last few decades, particularly since the turn of the century."

Some have recently argued that one short-term solution to the current fiscal crisis would be for the government to provide a boost to the housing market, which would again make land sales easier.

The government has put in place curbs on the housing market, such as restrictions on the number of properties people can buy, in order to quell activity, resulting in property price falls in big cities.

Louis Kuijs, chief China economist of Royal Bank of Scotland, based in Hong Kong, believes this has had a significant effect on the local government fiscal position.

"In my view the downturn in real estate has a major impact on government finances, especially local government finances, where land sales play a large role. However, I do not see the current real estate downturn as a cyclical issue that will soon be over."

"Given the large inventories of unsold housing, it will take quite some time before construction can start to expand substantially again."

The big question remains as to where this might lead and whether a Charlene Chu-style debt crisis could ensue.

There is no conclusive evidence that any given level of debt will trigger any particular outcome.

International comparisons of debt levels are often flawed because countries measure debt in different ways.

Analysis by Standard Chartered Bank last year put China's level of debt at 251 percent of GDP and compared that with 260 percent in the United States and 415 percent in Japan, by far the most indebted of the developed countries.

Japan, which has suffered debt deflation for more than two decades, is the nightmare scenario for China and one that Beijing policymakers are determined to use all levers possible to avoid.

Linda Yueh, adjunct professor of economics at the London Business School, visiting professor of economics at Peking University and also chief business correspondent of the BBC, says it is difficult to assess the true risk of China's current debt position.

"It is hard to compare because China's system is so different, particularly with respect to the sizeable state-owned sector that includes commercial banks. Banks are a big source of fiscal risk in many countries now so transparency of the banking system is an important part of assessing risk."

Some believe that developing economies like China find it more difficult to carry debt than developed countries because they do not have the established wealth or sophisticated financial markets to deal with it.

Ambrose Evans-Pritchard, international business editor of the Daily Telegraph in London, says China's position is not easy to interpret.

"Developing countries tend to have a much lower threshold compared to mature economies that have a huge layer of wealth and very liquid deep bond and capital markets," he says.

"China though is a very interesting case because it is in between the two in many ways, and that raises all sorts of questions. Just how much space does it have?"

Evans-Pritchard is worried about the historical precedents for China regarding the rapid rise in its debt levels over the past six years.

"When ratings agencies look at levels of debt it is the speed at which they have risen as well as the volume. The major disasters and credit bubbles in the post-war era have typically seen a 40 to 50 percent increase in debt as a percentage of GDP in the five years that have preceded them."

"That was the case of South Korea into the 1997-98 crisis, the Japan collapse from 1990 onward and was the same with the subprime boom in the US from 2002 to 2007 and it was probably most extreme in the Spain property bubble in the last decade. After China let rip in 2009, it had something like a 100 percent increase in debt. It has stirred up some huge problems from where it will be difficult to gently engineer soft deflation."

A unique feature of China's debt is that it is mostly in the real economy, with a lot of corporate borrowing in contrast to the West, where it is mostly is in the financial sector.

Liu at the CEIBS Lujiazui International Finance Research Center says this carries its own risks.

"You have this very high debt problem in the real economy, especially in shadow banking, where companies are paying very high interest rates. At the same time you have overcapacity in many sectors, companies facing more competition when selling their products and also the economy slowing down.

"This is a big risk for the Chinese economy, and at this moment that risk is increasing, not diminishing."

All this could be manageable, however, because another unique distinguishing feature of China's debt is that it is owed to itself and not to foreign countries. This makes it very different from Latin American countries in the 1980s, for example, which had massive external debt.

Innes-Ker says this may be the key factor in China avoiding a debt crisis.

"It is not huge levels of debt in themselves that are a predicator of a financial crisis. The danger comes when you have high levels of foreign debt and you become vulnerable to foreign investor sentiment and things like currency movements.

"This is just not the case with China. Indeed, it is one of the things they might explore in the future to be a bit more reliant on foreign debt because it is at such low levels at the moment, you could happily increase it without creating any substantial danger."

The solution to China's fiscal problems relies to a large extent on finding a new model for local government funding.

The central government has already put in train proposals to reform what many see as an unnecessarily complex system.

Local governments have until recently been banned from taking on debt and borrowing from banks.

However, they have been able to get round the rules by setting up arms-length local government funding vehicles, which have enabled them to borrow off their fiscal balance sheet.

Last September, the government lifted this ban, which had been in place since 1993, and paved the way for tens of the major local authorities to sell bonds.

Yueh at the London Business School believes the government needs to go further and give local authorities tax-raising powers. At present all the major taxes in China are raised centrally.

"China needs to reform its tax system so that it better reflects the semi-federal structure of the country. Central and provincial tax divisions should better reflect spending priorities and ease of collecting taxes. The US system is not perfect but holds lessons," she says.

There could be a lot of resistance to local taxes being introduced since it would mean people and businesses having to pay taxes for the first time

Innes-Ker recalls a revealing session at an EIU-hosted conference in Beijing in October.

"During one session, the audience was asked whether they thought a local property tax was necessary. Everybody in the room put their hand up. They were then asked whether they would be willing to pay it and nobody at all put their hands up. It was quite a funny moment and everybody laughed."

There is also the question of how much fiscal responsibility and independence local authorities will have, if the government does devolve revenue-raising powers.

Zhu Ning, deputy director of the Shanghai Advanced Institute of Finance, believes they will still have a tendency to overspend because they will know they can ultimately be bailed out by the central exchequer.

"There was a pilot program back in 2012 with Zhejiang, Chongqing and Guangdong able to issue bonds. They actually ended up trading at a lower yield than (China) treasuries," he says.

"This was because those who bought them thought they were safer than central government bonds on the reasoning that the government would not stand by and do nothing if there was a problem with this funding. So you weren't creating this independence or financial discipline that is required of this process."

However, as China's leaders meet in Beijing, not everyone believes that fiscal austerity is the right way forward for China.

Over coffee at the Maan Coffee House on Wangjing Xilu in Beijing, Liu Zhiqin is one of those dissenters.

The senior fellow at the Chongyang Institute for Financial Studies at Renmin University of China believes reining in budgets could be counterproductive and store up more fiscal crisis if it brings growth to a shuddering halt.

"In my view government economic policy is too passive. I think if it pursues an austerity policy this year and cuts government expenditure, it would be the wrong thing to do."

"It should instead pursue an active growth policy and stimulate the economy."

Liu believes it is vital that China invests in putting in place a proper healthcare, education and social security system, which will provide the basis for future long-term growth.

"One particular focus should be the aging population. We now have 200 million people over 60, that is a larger number than the population of almost all countries in the world. By investing in healthcare, there is the opportunity of keeping them economically active for longer and that could be a major stimulus to the economy."

Such fiscal expansionism is unlikely to be the consensus view at the two sessions, however.

But China's leadership is facing something of a policy conundrum. The short-term problem that is threatening a fiscal crisis remains the recent sharp slowdown in the property market.

This has hampered the ability of local authorities to sell land to developers and led to a dramatic shortfall in income. There remains a temptation therefore to introduce measures to resort to boosting the real estate sector.

Yueh believes policymakers need to resist taking this course at all costs.

"Fiscal revenues, particularly at the local government level, are linked heavily to real estate, but that doesn't mean that the sector should be boosted to address short-term fiscal issues."

"Over-reliance on the property market isn't a sustainable fiscal source, so it is a good opportunity to wean local governments off land sales and instead prompt them to help develop a working, liquid, local bond market so they can better manage revenue shortfalls through borrowing and increase their market discipline by being subject to the borrowing costs set by bond markets that can prompt more responsible policies to win over investors."

Xin Zhiming contributed to this story.

andrewmoody@chinadaily.com.cn

Ambrose Evans-Pritchard, international business editor of the Daily Telegraph in London. Nick J. B. Moore / For China Daily

Liu Zhiqin, senior fellow of Chongyang Institute for Financial Studies at Renmin University of China. Wang Jing / China Daily

Zhu Ning, deputy director of the Shanghai Advanced Institute of Finance. Zou Hong / China Daily

(China Daily European Weekly 03/06/2015 page1)