Reforms are on the backburner as central and local governments try and stimulate growth.
In recent months, China’s fiscal revenue has grown more slowly than has fiscal spending. Central and local governments’ fiscal revenues increased about 8 percent year on year in April, while national fiscal spending rose by 33 percent. Fiscal spending the first quarter of 2015 measured at 7 percent, the lowest rate of growth since 2009. The divergence between revenues and spending has resulted from a slowdown in growth, as well as from inefficiencies faced by local governments. Now, the Ministry of Finance and State Council have allowed for local governments to once again tap local government financing vehicles (LGFVs) for funds. While this may alleviate the fiscal spending slowdown, in the long run, this may result in a surge in non-performing loans that will act as a drag on future growth.
The economic slowdown has been in place for almost a year now. Growth in property investment and in industrial output continues to be rather sluggish, at 6 percent and 5.9 percent year on year, respectively in April. Loose monetary policy has been unable to boost spending. As economic activity dwindles, tax revenues have fallen. Yet the pressures to spend have only risen, as the government fills in the spending gap.
Local governments have faced mounting debt due to excessive spending on infrastructure and other projects requiring fixed asset investment. They have been ordered to speed up fiscal reforms by the Ministry of Finance. To assist local governments in reducing high levels of debt, the People’s Bank of China has asked banks to replace legacy debt with local government bonds, and permitted banks to use local government bonds as collateral for central bank loans. Banks are required to accept a minimum amount of bond placements.
What is more, local government financing vehicles, which had generated the excess debt in the first place, have been allowed to again act as borrowers for local governments. Banks are supposed to lend to local government financing vehicles in particular for agriculture, affordable housing, and urban rail projects.
The latter has been greeted with shock and concern, since local government financing vehicles racked up trillions of RMB in debt through the end of 2013 and beginning of 2014. Local government financing vehicles are the entities responsible for building the now-infamous ghost towns and other unproductive fixed investment projects. Curbing their behavior, and in particular allowing local governments to roll over debt into bonds, with an admonishment to reform fiscal spending, appeared to address the problem of debt accumulation. The recent moves by the State Council now likely reverse that correction.
One reason that the leadership is in such a bind with local governments is that fiscal imbalances between the central and local governments have still not been corrected. Local governments have been desperate for sufficient revenue to cover their massive expenditures on social services and infrastructure and continue to face no reprieve. The recent fiscal reform appears to have even skewed revenues a bit more in favor of Beijing, as service enterprises will switch from paying the business tax, which generally goes to local governments, to the VAT tax, which is transferred to the central government.
Another reason why local governments were allowed to use LGFVs is because the attempt to expand the municipal bond markets was insufficient. Local governments rolled out 400 billion RMB in 2014, which proved insufficient to finance local government projects. Land sales have also slowed, resulting in smaller revenue intake.
China needs additional fiscal reform, particularly with redistribution from central to local coffers, but this is unlikely to happen as both central and local government are pressed for funds to stimulate growth and implement reforms. Certainly the leadership has a challenging road ahead. The reversal on local government debt channels is just one harbinger of obstacles to come.
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