Current situation is sound, despite mounting local government debt

The Chinese government's fiscal deficit was one of the hottest topics across the country as the annual CPC and CPPCC meetings began. According to economists, China will probably increase its deficit to about 2 trillion yuan ($318 billion; 288 billion euros, and above 2.5 percent of the nation's GDP) to effectively implement its fiscal policy and boost economic growth to a level policymakers are comfortable with.

On the surface, China boasts one of the soundest fiscal situations and has one of the healthiest balance sheets among all leading economies. According to a recent study by the Ministry of Finance, total assets of state-owned enterprises reached 104.1 trillion yuan in 2013, almost twice the 2009 figure of 53.3 trillion yuan.

In addition to China's bulging national balance sheet, let us not forget that China also boasts the largest foreign reserve in the world, valued at over $4 trillion by the end of 2014. To put things into perspective, China's foreign reserve is about four times the size of Japan's and is the world's second largest.

To counter the slowdown in China's economic growth, the government has been using its fiscal might to stabilize the economy. These efforts have run in parallel with the governments' determination to improve education, healthcare, job training, unemployment benefits and environmental protection.

These are not trivial projects, and they are all costly. To be more effective with its fiscal policy, the government has shifted from its traditional conservative attitude with regards to dealing with a fiscal deficit and has begun running a deficit to finance its targeted goals of improving education and affordable housing.

In 2012, China maintained a modest budget deficit of 0.8 trillion yuan, or about 1.5 percent of concurrent GDP. The fiscal deficit increased to 1.35 trillion yuan (2.1 percent of GDP) in 2013 and to more than 1.5 trillion last year. These figures lie well within the 3 percent safety range set by the European Union and international communities. In contrast, the fiscal deficit of the United States reached $1.56 trillion, or 10.9 percent of its GDP, in 2011. The fiscal deficit problem in Japan is worse.

Therefore, despite an expected rise in the size of the deficit to 2 or even 2.5 percent of GDP, the central government should at the moment have little difficulty in maintaining its creditworthiness and fiscal soundness.

But with China's economic growth slowing and its economic growth mode shifting, it becomes imperative to inspect the nation's fiscal sustainability. We must ask: Is everything about to change?

Even at such a modest and controllable size, the speed at which China's fiscal deficit has risen has raised eyebrows. After all, it took China three years to increase the size of its fiscal deficit by 1.2 trillion yuan.

To assess the dynamics of Chinese fiscal situations, it may help to pay attention to two recent noteworthy patterns that have emerged in the central government budget report.

First, the growth rates for both fiscal income and expenditure were much slower in 2012 than in 2011 (24.8 percent to 21.2 percent) and for most years of the past decade. This can be largely attributed to the slowing economy, and in changes to how income is distributed between the state and its people. Secondly, the growth in fiscal expenditure outstrips fiscal income growth by a wide margin.

Thus, we are seeing a trend in which fiscal income is growing more slowly and fiscal expenditures are growing more quickly. With fiscal income slowing, the government is left with no option but to slow expenditure growth or run a fiscal deficit. This is not something that is easily reversible, given that the government needs additional funding to reform social security, education and healthcare, all issues that the average Chinese household cares a great deal about.

Even with the slowdown in economic and fiscal income growth, the central government should have little trouble in dealing with these problems - that is, if these are the only problems that it has to deal with.

But the bigger question seems to be: Does the central government deficit reveal a complete and accurate picture of the nation's fiscal situations?

According to a Chinese Auditing Office study in 2013, total government debt, including contingent debt that is guaranteed by the central government, stood at 30.3 trillion yuan, 17.9 trillion yuan of which was debt accrued by local governments. That is a 67 percent increase from the 2010 figure of 10.7 trillion yuan.

The speed by which local governments have accrued debt over the past three years is alarming. Based on the same rate of growth, total local government debt may well increase to more than 50 trillion yuan - the size of 2013's GDP - by 2020.

Because Chinese local governments are not technically allowed to issue bonds or raise debt independently, local governments have set up numerous financing vehicles to raise capital. In addition, state-owned enterprises, especially local ones, have provided much needed services to local governments pro bono.

Such kindness is not entirely altruistic. It is worth stressing that because no government but the central government enjoys fiscal independence, all lower-level government and SOEs derive their credit worthiness from the creditworthiness of the central government. Essentially, the central government provides a level of guarantee, more often implicit than explicit, to the debt by local governments and SOEs. SOEs want to help local government because that is where they get their meal ticket.

To this end, even though the central government's fiscal situation seems safe and sound for now, at 2.5 to 3 percent of GDP, the uncertainties with the implicit guarantees that the central government provides around the country is what really defines the nation's future fiscal situations.

The author is a faculty fellow at the International Center for Finance at Yale University and deputy dean of the Shanghai Advanced Institute of Finance at Shanghai Jiao Tong University.

(China Daily European Weekly 03/06/2015 page9)