However, when China’s economy came to a standstill in 2008, the major pillars of local government finances collapsed, once again weakening local budgets and leaving them unprepared to support the enormous amounts of economic stimulus spending imposed by the Chinese government in 2009.
At present, many local governments rely on government financing to remain solvent, and their poor financial condition is largely obscured by the support provided by generous credit policies. We believe this will ultimately give rise to even greater risks.
The latest method of financing local governments is the "creditization" of debts arising from infrastructure investments and other government activities. A "bank-trust-city financing platform" has been established, whereby the government subsidizes the issuance of local bonds through city investment and financing corporations.
Corporate debts issues by these special purpose entities amounted to 21.6 billion yuan in 2007, 33.1 billion yuan in 2008 and a massive 60.6 billion yuan in the first five months of 2009. These debts accounted for 12.6%, 14.0% and 41.8% of all corporate debt in China for 2007, 2008 and 2009, respectively.
As new waves of investment give rise to more of these debt arrangements for local governments, the efficiency of these investments begins to look suspect.
According to the Institute for Fiscal Science Research (under the Ministry of Finance), the total debt of local governments in 2008 was 5 trillion yuan, equivalent to 16.3% of GDP, 81.6% of annual revenue, and 183% of local revenue for that year. As an example, the total debt in Shanxi Province amounted to 127.2 billion yuan (excluding hidden debt), equivalent to 23.2% of GDP. This included 88.6 billion yuan of direct debt, 34.5 billion yuan of secured debt, and 4 billion yuan of registered accounts.
In addition, some regional statistics indicate that during the first quarter of 2009, local governments have financed 500 billion yuan through corporate bonds, medium-term notes, short-term financing and a variety of "bank and credit" products. Most of these funds have been earmarked for transport infrastructure and other public construction projects with questionable investment efficiencies. This will undoubtedly cause further deterioration in the financial stability of local governments.
I believe the government should not be too concerned about deficits at the moment. According to my calculations, if China's fiscal deficit maintains at a rate between 2.5% ~ 3.8%, this will have no long term negative impacts. Given that, there is still a lot of room China’s expansive fiscal policy.
Rather, the government’s focus should be on the source of structural financial imbalances in provincial budgets �the "creditization" of local investment-related debt.
In order to better regulate local government finances, new capital investment projects should be restricted. At the same time, financing programs should be managed more tightly in order to prevent their misuse by local budget managers.
Monetary policy should remain independent of fiscal policy in order to prevent local governments and banks from hijacking credit platforms to subsidize unnecessary infrastructure investment.
(The author is the vice president of School of Economics, Renmin University of China. E-mail: rmulyc@vip.sina.com)