Now, Beijing must take fiscal decentralization further, giving each local government the authority to collect taxes and control its budget’s scale and structure. Only by adjusting the distribution of public finance can China’s leadership help local governments decrease their reliance on land-transfer revenue and bank loans.
The next challenge for China’s leadership is to establish better mechanisms for ratification and approval of the overall budget, which comprises the general public budget, the government fund budget and the budget for state-owned capital. Currently, while sub-national governments are required to submit their budgets for approval to the people’s congress immediately above them, as well as to the National People’s Congress, the drafts undergo little scrutiny. Ensuring that all budgets are reviewed by people’s congresses at various levels would enhance resource efficiency by reducing fiscal competition between the central and local governments, as well as among local governments.
China can further enhance the capacity of existing financial resources to support the real economy through financial decentralization. In recent years, the central government has tightened its control over the banking sector, undermining the financial system’s development, not least by impeding banks’ ability to assess credit risk. By forcing banks to offer lower interest rates to state-owned enterprises, the government drove private firms and households to informal lenders, fueling the emergence of a large and risk-laden shadow-banking sector.
Likewise, the requirement that banks offer very low or even negative real interest rates to private depositors drove them to invest in fixed assets, leading to overcapacity in some sectors, such as real estate. As a result, market-oriented interest rate reform is now needed to help optimize capital allocation and support the development of China’s financial market, thereby laying the groundwork for future capital account and exchange rate liberalization.
Financial decentralization extends beyond interest rate liberalization. Breaking the central government’s domination of China’s financial resources will fundamentally change the system of implicit guarantees that is currently generating significant financial risk. It will also help to synchronize financial development between urban and rural areas, ultimately eliminating China’s longstanding dual financial structure.
If Beijing’s leaders are genuinely committed to revitalizing the capital stock, they must begin with fiscal and financial decentralization. Such an approach would promote efficiency, stability, innovation and dynamism at the local level — exactly what China needs to support its progress toward advanced-economy status.
Zhang Monan is a fellow of the China Information Center, a fellow of the China Foundation for International Studies and a researcher at the China Macroeconomic Research Platform.
Copyright: Project Syndicate