In coming years, China’s government will have to confront significant challenges to achieve stable and sustainable economic growth. Yet with mounting fiscal and financial risks threatening to derail its efforts, policymakers must act quickly to produce prudent, forward-looking policies.
The biggest medium to long-term threat to China’s fiscal position is in the implicit guarantees system that Beijing has established for local-government debt. Since the global financial crisis, local governments borrowed heavily to support China’s massive stimulus program, amassing debt worth 10.7 trillion yuan (US$1.7 trillion) by 2011.
China’s leaders hope to control risks from local-government investment vehicles (LGIVs) by limiting bank lending. The balance of bank loans to LGIVs increased only slightly last year, to 9.3 trillion yuan, from 9.1 trillion yuan in 2011. The China Banking Regulatory Commission has called on banks to retain last year’s LGIV loan quotas for this year, ensuring the overall balance of loans to LGIVs does not exceed the 2011 year-end total.
However, LGIVs obtained huge amounts of financing last year by issuing bonds and trust loans. This includes 250 billion yuan in local government bonds, 636.8 billion yuan in urban investment bonds and technical cooperation trust-fund projects, totalling 501.6 billion yuan, representing year-on-year increases of 50 billion yuan, 380.6 billion yuan and 247.9 billion yuan respectively.
Yet even with these funds, local governments have struggled to make ends meet. Tax reforms implemented in 1994 caused local governments’ share of national fiscal revenue to decline, from 78 percent in 1993 to 52 percent in 2011. Yet over the same period, their share of total government expenditure increased from 72 percent to 85 percent.
Needing to fill the gap has forced local governments to depend on land sales, but this income has dropped from 32 percent of total revenue in 2010 to 20 percent last year. Central government measures to control surging real estate prices will keep reinforcing the trend, increasing pressure on local government revenues.
The risk from local government debt is exacerbated by large amounts of non-explicit debt acquired through arrears, credits and guarantees. When a local government cannot service its debt, the central government must assume the responsibility.
China’s financial stability is also at risk, as lenders turn to unofficial channels to circumvent tighter government regulations on the formal banking system. Perhaps the biggest risks stem from China’s rapidly growing shadow banking system.
Shadow banking can be conducted through trust loans (extended by trust companies), entrusted loans (company-to-company credits brokered by financial institutions), bank acceptances (company-issued drafts or bills that are endorsed by banks) and corporate bonds (debt securities issued by companies directly to investors). Their combined worth reached 5.9 trillion yuan last year, led by corporate bonds (2.3 trillion yuan).
New lending by trust companies — which rose by more than 400 percent last year — is creating huge solvency risk, since it is often extended to higher-risk entities, including real-estate developers and LGIVs. A spike in defaults could destabilize the entire financial system and trigger an economic downturn. Trust loans tied to LGIVs ultimately enjoy the same implicit guarantee from the central government as official bank loans.
Regular banks, too, are trying to evade new regulations by ramping up off-balance-sheet lending. It is increasingly common for banks’ off-balance-sheet lending to exceed newly issued balance-sheet credit. From 2011 to 2012, such lending grew by 1.1 trillion yuan, reaching 3.6 trillion yuan (23 percent of total bank financing), while balance-sheet lending increased by only 732 billion yuan.
However, the former is usually implicit and uncertain, making it vulnerable to default. If faced with such losses, banks might choose to protect their reputations by using official funds for repayment, transferring the risk onto their balance sheets.
Overall, the rapid credit risk growth increases inflationary pressure and fuels the formation of asset bubbles. Conversely, when the monetary authority tightens credit too quickly, asset prices become more volatile, resulting in more non-performing loans and triggering economic shocks.
Beijing must implement macroeconomic policies now to minimize future risk escalation. Medium and long-term fiscal stability requires policies tackling the growing disparity between fiscal revenues, which are suffering from slowing GDP growth and expenditures, and will be driven up by structural tax cuts and increased social-welfare spending.
To manage growing pressure on public finances, China must establish highly efficient public-budget and fiscal-restraint systems. It must tighten financial supervision, improve budgetary management and enhance the efficiency of fiscal policies.
China also needs a new financing model for infrastructure projects. The current one relies heavily on LGIV loans and fiscal expenditures. More stable financing channels and stronger enforcement of operating standards are essential to support rapid urbanization.
As prudent fiscal and financial policies gradually stabilize China’s economy, monetary policy must remain neutral. Loosening monetary policy would significantly increase the risks stemming from local government debt and shadow banking, while tightening monetary policy would fully expose those risks, posing a serious systemic threat.
With the right balance of vision and caution, China’s leaders can tackle the buildup of fiscal and financial risk. If they fail, China’s leadership of the future global economy will hang in the balance.
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