Since the eruption of the global financial crisis in 2008, China has used massive economic stimulus to sustain GDP growth. However, unresolved structural problems have meant that the stimulus packages generated significant fiscal and financial risk, while doing little to improve China’s capital stock.
While China’s overall capital stock is by no means small, capital structure and maturity mismatches have led to the accumulation of massive volumes of non-performing assets, undermining China’s economic stability and financial efficiency. To create the stability needed to reach the next stage of economic development, China must shift its focus from sustaining high GDP growth, to revitalizing its capital stock.
China’s new leadership seems to recognize this. Chinese Premier Li Keqiang (李克強) has said that the government will not introduce any additional economic stimuli; instead, the authorities will pursue profound and comprehensive economic reform, even if that means slower GDP growth.
Moreover, Li has called upon the banking sector to reinvigorate idle capital and allocate incremental capital more effectively. The Chinese State Council recently published Guidelines for the Structural Adjustment, Transformation, and Upgrading of the Financially Supported Economy, which outlines 10 key measures for revitalizing the capital stock.
This implies major macroeconomic reforms. China’s government is now attempting fiscal decentralization to revitalize the public finance position, while adopting financial decentralization to maintain currency stability. The quest for macroeconomic balance has become the government’s main economic policy goal.
Over the past three decades, the gradual decentralization of China’s fiscal management system enabled it to regulate fiscal transfers to sub-national governments, with the primary aim of clarifying revenue and expenditure at all levels of government. So why did local government balance sheets swing from surplus to deficit over the same period?
In 1994, China’s economic reform process reached a turning point with the introduction of a tax distribution system that reduced the proportion of tax revenue held by local governments from 78 percent in 1993 to 52 percent in 2011, while raising the proportion of expenditure from 72 percent to 85 percent over the same period. Faced with intense competition to contribute to GDP growth, local governments were compelled to seek other ways to augment fiscal revenue.
As a result, they turned to land transfers and debt financing, exacerbating the problem of soft budget constraints. Cash-strapped local governments began seizing farmland to sell it to commercial real-estate developers, while accumulating massive debt through off-balance sheet loans and short-term interbank funding to finance local government investment vehicles and real-estate investment. In doing so, they dramatically increased their financial vulnerability.
By the end of last year, the combined liabilities of 36 of the most indebted Chinese local governments totaled about 3.8 trillion yuan (US$620 billion), up nearly 13 percent from 2010. Furthermore, a large proportion of the credit was invested in the overheated real-estate sector, as well as in infrastructure projects with low rates of return, creating large-scale structural overcapacity that has undermined the efficiency of investment and resource allocation, and contributed to the structural mismatch of fiscal resources.