Yao Yang calls for distributing cost of local govt debt resolution, imposing market discipline
Yao Yang calls for distributing cost of local govt debt resolution, imposing market discipline
Dean of PKU National School of Development proposes including SOEs in govt budget to prevent new debt risks
Peking University’s National School of Development (NSD) held a seminar on China’s local government debt risks on September 9, where, in the live-streamed event, six scholars six scholars shared their thoughts and answered questions.
Below is the speech given by Yao Yang, Professor and Dean of the NSD, sourced from its website.
姚洋：地方债的化解方案与必要的治理改革
Yao Yang: Local Government Debt-Defusing Program and Necessary Governance Reforms
Over the past two decades, despite implementing two rounds of local government debt resolution measures, the volume of debt has continued to grow cyclically. This necessitates our introspection. Notably, between 2014 and 2018, which should have been a window for defusing debt, the debt skyrocketed. The situation became worse after 2020. This indicates that previous debt-defusing measures were ineffective, and in some cases, counterproductive.
The debt cycle emanates from local governments’ imperative for development. Some argue that the increase in local government debt in China results from an unequal distribution of duties and responsibilities, and revenues between the central and local governments. (Local governments, responsible for dealing with complex issues directly related to people's well-being, face limited financial resources compared to the central government.) I am skeptical about this. Even if local governments' responsibilites and financial resources were balanced, local governments would still seek borrowing. Presently, the central and local governments essentially share 50% of the recurring income each. However, central government expenditure accounts for only 15% of the total governmental expenditure, leaving 85% to the local governments. Despite this, local governments continue to raise money by borrowing money, indicating that the issue isn't a disproportionate income distribution. Instead, an intrinsic drive for development serves as the genuine motive for local governments to incur debt. This trend is not unique to China; local governments worldwide, including those in the U.S., Europe, and Japan, all engage in debt-raising practices.
Root Causes of Local Government Debt Issues
Of course, financial pressures and the impulse to borrow alone do not constitute a local government debt crisis; the rapid growth of local government debt, eventually leading to a crisis, has other underlying causes.
Firstly, the Budget Law of the People’s Republic of China specifically regulates only national debts, which, at the local level, comprises local government debts, but does not extend to cover the commercial debts of the government. The crux of the local government debt issue primarily involves commercial debts incurred by local governments. Local governments heavily borrow from banks or issue debt on the open market through financing vehicles and other local state-owned enterprises, commonly referred to as 'municipal corporate bonds' (城投债). According to the law, these bonds are classified as corporate debts, and local governments are not legally obligated for their repayment (only the issuer are). However, in practice, most of these debts end up being repaid by local governments. The absence of any defaults on municipal corporate bonds to date suggests that they function as a form of government debt. When discussing the local government debt issue, we are primarily addressing the commercial debts of local governments. One major legal issue we're grappling with right now is the surprising absence of any legal regulations for the commercial debts by local governments!
Secondly, the ability of local governments to borrow irresponsibly is linked to the characteristics of our nation's system. China operates under a unitary system where local governments derive their authority from the central government. This means that the central government ultimately bears responsibility for the actions of local governments. In contrast, in federal states, the authority of the central government is derived from the local governments. In such countries, local governments can resort to bankruptcy as a means to escape debt. For example, Detroit once declared bankruptcy, shedding its debts and gradually recovering (of course, it faced market discipline, and borrowing became more challenging after bankruptcy). However, local governments in China are not allowed to declare bankruptcy.
In 2014, during discussions on amending the Budget Law, I opposed a system where local governments can incur debts without bearing the final responsibility because such a system creates a significant moral hazard, allowing local governments to evade responsibility, borrow extensively, and then rely on the central government for a bailout.
Thirdly, the frequent rotation of China's officials intensifies moral hazard. This practice is rooted in China's longstanding system of rotating officials, designed to prevent nepotism by not allowing officials to stay in one place for too long. However, these short tenures often lead to borrowing sprees. While end-of-term audits can somewhat mitigate this behavior, distinguishing between reasonable and unreasonable debts becomes a challenge. Consequently, officials can exit their positions without facing repercussions, which entails another dimension of moral hazard.
In summary, China's debt problem is fundamentally a political economy issue, not just an economic one. The interplay between politics and economics is crucial in our inability to manage debt.
To address the current round of local government debt, I propose a three-step approach. The initial step entails offering fiscal assistance to local governments, the second concentrates on defusing existing local government debt, and the third strives to prevent the accumulation of new debts.
Fiscal Assistance for Local Governments
At present, local governments face substantial financial challenges, leading to significant expenditure reductions. In response, some local governments have resorted to distorted behaviors, including overtaxing businesses. This not only severely impacts the confidence of private enterprises but also acts as a major impediment to economic recovery. The primary cause of local governments' fiscal woes is the prolonged impact of the pandemic. According to estimates by Bai Chong'en, the pandemic has resulted in a cumulative fiscal deficit of 4 trillion yuan (560 billion USD) for local governments over three years. The current debt-defusing plan, totaling approximately 1.5 trillion yuan (210 billion USD), falls short and is inadequate to address the fiscal difficulties faced by local governments. Therefore, I propose that the central government issue special bonds worth 4 trillion yuan to alleviate the financial strain on local governments. While this may appear contradictory to the debt-defusing objective, it is a necessary and temporary measure by the central government.
Resolving the Local Government Debt Stock
It's clear that most local governments cannot repay their debts. While some developed regions might have the capacity to do so, the vast majority of local governments don't have the financial strength. Between 2014 and 2018, China underwent a debt replacement, which essentially transformed short-term commercial debt into long-term local government loans sanctioned by the central government. This was merely a shift of debts; local governments still need to repay over time.
Drawing from the lessons learned in the first two rounds of debt-defusing efforts, a comprehensive solution is necessary. The currently discussed 1.5 trillion yuan debt replacement program falls short, as it fosters opportunistic behavior among local governments and financial institutions. Provinces which reported higher debt stand to gain more, receiving larger replacement quotas. Furthermore, a more troubling issue emerges: the rescue of irresponsible financial institutions. The debt swap from 2014 to 2018 allowed these institutions to evade losses, bolstering their 'confidence' and reinforcing their 'belief in municipal corporate bonds.' Consequently, they continued to invest in municipal corporate bonds issued by local governments. It's evident that some cities should never have issued bonds or borrowed from banks, yet these financial institutions continued to place trust them.
A comprehensive debt resolution program in the late 1990s adopted a different approach. Then, Premier Zhu Rongji implemented highly stringent measures that essentially restricted the financing capabilities of local governments and initiated a restructuring of the banking sector. Throughout this period, the banking system bore the majority of explicit costs, as their bad debts were discounted and sold to asset management companies, resulting in capital overruns and the need for restructuring. Meanwhile, local governments took on implicit costs, mainly associated with the expenses of state-owned enterprise reforms.
This time, I believe China should embark on a comprehensive debt restructuring, ensuring the active participation of all stakeholders and holding everyone accountable, especially financial institutions.
China can take a cue from the first round of debt resolution in the 1990s by allowing asset management companies (AMCs) to take over some local debts. Similar to the Real Estate Investment Trusts (REITs) proposal for Public-Private Partnerships (PPP) projects mentioned earlier, China can bundle local debts. As in the first round of the debt resolution process, these debts must be discounted. This may necessitate local governments to provide high-quality assets; otherwise, without underlying assets, AMCs would lack the incentive to take on the debt.
While the details of this plan require further discussion, the direction can be clear: a comprehensive package of debt-relief measures is essential, with all stakeholders sharing some of the burden. A comprehensive plan is essential, as the existing debt stock of local governments has become a massive burden, impeding their operations. Distributing the losses among all stakeholders is not only fair but also essential to instill necessary discipline.
Preventing New Debt
After resolving existing debt stock, the focus should be on preventing new debt.
Over the past two decades, despite efforts to defuse debt, new debt has continued to emerge. This is primarily a result of the strategic interactions between the central and local governments. Local governments often managed to obfuscate their responsibilities, ultimately securing concessions from the central government. While various measures have been rumored to be proposed to prevent the accrual of new debt, measures in these rumored proposals had been implemented before and proven ineffective.
Here, I propose a radical suggestion: integrate all state-owned enterprises' budgets and final accounts into the corresponding level of government's budgets and accounts. Why can state-owned enterprises in developed countries perform well? Take, France, for example. The finances of French state-owned enterprises are integrated into government budgets. For instance, if Renault Group performs poorly, the French Prime Minister is held accountable.
We know that most local state-owned enterprises are not profitable, with only a few central enterprises being profitable. So, why do local governments even bother to operate state-owned enterprises, including financing vehicles? The reason is that these enterprises serve as the 'white gloves' of local governments, acting as intermediaries that handle financial matters discreetly. This enables them to finance or manage issues that shouldn't be openly addressed by local governments. Through these vehicles, local government's finances become financialized. Consequently, China should integrate these enterprises into the financial management of local governments.
This approach has three advantages:
Firstly, it introduces transparency and openness to debt, placing pressure on local governments. International rating agencies evaluate the sovereign debts of nations, imposing constraints on their borrowing. Once local debt becomes publicly known, the debt of each city and county can undergo rating assessments. This will exert pressure on local governments, facilitating the evaluation of the debt performance of local officials. Additionally, it can function as a robust and effective mechanism for auditing the debt when officials leave their positions.
Secondly, it has the potential to enhance the central government's fiscal oversight of local governments. In the past two decades, the Ministry of Finance has made strides in standardizing the management of local budgets and final accounts, but there is still a lack of effective management for off-budget commercial entities of local government. Given that these entities serve as instruments for local government revenue financialization, regulating them becomes crucial.
Thirdly, it strengthens the role of local People's Congresses [China's local legislatures]. As the debt of financing vehicles is considered corporate debt and is not currently included in local budgets and final accounts, local People's Congresses are unable to exercise oversight. As per my suggestion, including these debts in local budgets and final accounts would prompt representatives in the local People's Congresses to conduct thorough reviews, establishing effective oversight over local debts.
In summary, the integration of local commercial debt into local government budgets and accounts enhances central and local oversight while leveraging market scrutiny. Moreover, permitting defaults on municipal corporate bonds and bankruptcies of local government financing platforms can instill robust market discipline, deterring investors from blindly acquiring local government debt and banks from indiscriminate lending to local governments.
Pekingnology and its sister newsletter The East is Read have extensively covered the recent intellectual debate about China’s government debt challenges.
Xu Shanda, Deputy Director of the State Tax Administration of China (2000-2006), says in addition to the known government debt China owes its unpaid VAT refunds to private enterprises, unpaid pensions contributions, and farmers who contributed compulsory labor and whose products were artificially discounted by the state.
Xu Gao, Chief Economist of Bank of China International (China), argues, in essence, there is local government debt in China as it is a unitary state.
Ting Lu, Chief Economist of Nomura Securities China, believes urbanization and real estate are key to government debt solution.
Yu Yongding, senior policy adviser who sat on the central banks Monetary Policy Committee (2004-2006), calls on Beijing to initiatie fiscal stimulus and stop following the 3% and 60% rules in the Maastricht Treaty in spite of debt challenges.
Luo Zhiheng, Chief Economist and President of the Research Institute at Yuekai Securities who recently sat at Chinese Premier’s July consulting with economists, says it’s necessary to further clarify the relationship between the government and the market, define the scale and responsibilities of the government, and prevent local governments, especially county-level governments, from falling into a state of nearly unlimited liability.
