BEIJING – While parts of the world are dealing with the aftermath of the financial crisis or an emerging sovereign-debt crisis, China is coping with the risk of overheating and/or an asset bubble.
Many factors may be pushing China’s economy in this direction. One of the most worrying is the same which fueled the current crisis in the eurozone: mushrooming public debt. In the eurozone, the problem is member countries’ sovereign debt; in China, the problem is borrowing linked to local governments.
In the eurozone, a bloated social-welfare system, particularly for the rapidly growing population of retirees, and the economic slowdown caused by the financial crisis are key components of the structural debt problem. In China, local officials increased borrowing in order to ensure that their regions’ economic growth rates remain at double-digit levels.
There are, no surprise, commonalities between China and the eurozone. Obviously, debt accumulates wherever people want to spend more than they have saved. But a more specific similarity is that highly indebted eurozone countries and Chinese provinces and counties have been spending too much of a common currency.
Because these funds are not issued or controlled by any member country or local government, eurozone members and Chinese local governments cannot relieve their debt problems through devaluation. So, in both cases, when a debt is defaulted upon or loans become non-performing, the negative consequences are felt by the entire financial and monetary “zone” – the entire EU and all of China.
To avoid such an internal “sovereign debt crisis,” China’s Budget Law, adopted in 1994, forbade local governments from borrowing autonomously, either by issuing bonds to the public or by getting credits from banks. In theory, this means that local governments cannot finance their deficits by increasing their debt levels, because they can borrow only from the central government or other central authorities.
But the Budget Law did not end the problem. While local governments have been unable to borrow, locally controlled state-investment companies can. So it is no surprise that a huge volume of bank loans has passed through the local branches of state-owned banks to finance local public-investment projects.
These borrowings caused a surge in non-performing bank loans in the early and mid-1990’s, when total non-performing loans hit 40% of GDP. This caused a credit crunch and prolonged deflation in the late 1990’s, as the central government tried to clean up the mess.
Due to privatization of state-owned enterprises and improved financial regulation, including bank supervision and risk control, since 2000 both central and local budgets have basically been in good order. The ratio of total public debt to GDP was less than 22% in 2007-2008, before the global financial crisis. There was still some borrowing by local governments, of course, but on a limited scale (totaling 3-4% of GDP), owing to institutionalized surveillance of lending.
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 credits financing local investments increased six-fold in 2009 alone. Indeed, total borrowing by local government now amounts to roughly $900 billion, up from $150 billion year on year and the equivalent of almost 20% 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 been putting the brake on the growth of these debts 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 China. 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 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, hyper-inflation. 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.