China’s economic growth “miracle” has begun to be overshadowed by an evolving fiscal challenge. The depletion of local governments’ credit capacity has not only crowded out the rising demand for social security expenditure, but also undermined the financial health and confidence of Chinese households.
At a critical juncture of structural economic transformation, the sustainability of China’s local government credit is a pressing concern for long-term economic growth and social stability.
China’s tax revenue sharing reform, orchestrated by then premier Zhu Rongji in 1994, restructured China’s fiscal system to bolster central control of taxation, significantly diminishing local governments’ share of tax revenues and weakening their fiscal strength. As a result, local governments became increasingly reliant on non-budgetary revenue, particularly land use right transactions.
While the severe imbalance in the fiscal revenue structure was concealed during times of economic expansion, the inherent vulnerabilities of local government credit were always destined to come to the surface in more difficult economic times.
The national goal of maintaining a moderate to high GDP growth rate and the promotion criteria for Chinese local officials have both further exacerbated the financial strain. The GDP performance-linked advancement mechanism, paired with China’s rapid urbanization, has created a surge in demand for fiscal expenditure at the local level.
The 2008 Global Financial Crisis prompted China to launch a 4 trillion RMB ($547 billion) fiscal stimulus package, requiring local governments to raise 70 percent of the funds. In response, local government financing vehicles (LGFVs) were created, allowing local governments to utilize off-balance sheet financing and even shadow banks.
The ensuing rise in local government debts triggered scrutiny of credit transparency and sustainability in 2014. While a new budget law empowered provincial governments to issue public debts, efforts to curtail implicit debts — those raised beyond statutory limits or through illicit guarantees — were less successful. By the end of 2022, while the official explicit local government debt reached 35.06 trillion RMB ($4.8 trillion), the market estimated implicit debt surpassed 60 trillion RMB ($8.2 trillion), with Goldman Sachs projecting a total debt balance exceeding $13 trillion.
During its economic boom, surging local debt in China remained manageable as the direct returns from debt-funded projects and their long-term positive externalities often offset interest costs. Infrastructure initiatives such as the construction of new metro lines or highway connections can elevate land values and attract real estate investment, indirectly boosting local tax and land transfer incomes.
But during times of economic stagnation, the prolonged realization of governmental cash inflow poses a threat to debt sustainability. The direct returns alone cannot service the debt as the anticipated long-term benefits wane and debts come due prematurely.
China is the world’s most decentralized nation in terms of subnational spending. According to International Monetary Fund research, China’s local governments are responsible for 85 percent of general budgetary spending, bearing significant fiscal duties in areas such as pensions, medical care and unemployment insurance.
This arrangement faces challenges, especially as these areas experience rapid expenditure growth due to aging and urbanization. The existing stockpile of local debts compromises local governments’ capacity to deliver these public goods, which creates a negative feedback loop, diminishing private consumption and investment due to residents’ decreased expectations of future security.
Declining local public goods provision has been seen in the Guangxi Zhuang Autonomous Region. With one of the nation’s highest debt-to-revenue ratios, Guangxi’s fiscal strain became evident in the first half of 2023. Its social security and employment spending dropped by 8.7 percent, while health and wellness expenditure slipped by 0.4 percent.
The region’s fixed asset investment plunged by over 21 percent year-on-year, a decline significantly influenced by the private sector, which has historically constituted more than half of this investment. The feedback loop has dampened the private sector’s investment prospects, highlighting the adverse effects of social security expenditure being crowded out.
Commercial banks, especially the larger ones, are the primary financiers of China’s local government debts. Debt exposures could gradually influence the asset soundness and profitability of these banks. A noteworthy example is the debt restructuring strategy adopted by Zunyi Road and Bridge Construction Group, an LGFV from Guizhou province. The company negotiated an unexpected 20-year extension on its 15.59 billion RMB ($2.13 billion) bank loans, dramatically reducing interest rates and deferring principal repayments for the initial 10 years.
If this practice becomes prevalent, banks could encounter tremendous operational pressure. Depositors — namely Chinese households — might be endangered, which could undermine consumer confidence and long-term growth prospects.
Addressing local government credit sustainability is a delicate task, especially with tax reforms seeming unlikely. Given the central government’s leverage flexibility, introducing special-purpose bonds backed by state credit for social security expenditures could provide some temporary respite.
But long-term remedies such as structural reforms to boost investment confidence and nurture local tax sources, particularly those that promote a market-oriented economy and ease tensions in foreign trade, demand patience and strategic determination. In light of China’s local fiscal dilemmas and their potential ripple effects on the broader economy, urgent and decisive action is imperative.
Di Lu is a policy adviser at Olympus Hedge Fund Investments, based in China.