Why Local Government Debt Is Back on China’s Agenda

Amid recent talk of financial reform, China’s leaders have returned to a long-recurring theme—how to to tackle the problem of ballooning local government debt. At July’s Financial Work Conference, President Xi Jinping labeled local government debt as one of the financial system’s two major vulnerabilities (the other being state-owned enterprise debt). Soon after, Xi again brought up the problem but this time at a meeting of the Communist Party’s powerful Politburo. And last week, Premier Li Keqiang waded in, instructing the State Council to crack down on illegal local government borrowing.

But while the senior leadership’s attention to this issue is reassuring, it also speaks to its intractability—and the fact that local governments continue to put it on Beijing’s agenda.

As recently as 2015, it seemed that Beijing had definitively put the issue to bed. The central government imposed a debt ceiling on borrowing by subnational governments. And it pledged that there would be no bailouts. To ease their repayment pressures, local governments were permitted to issue bonds. Over the last three years Beijing has implemented a raft of reforms aimed at improving the fiscal position of local governments. Local government financing vehicles—the off-balance sheet entities that local governments universally use to get around borrowing limits—have been pushed to become viable, independent of government backing. This year alone, Beijing has released policies aimed at reducing local government’s discretion over borrowing and spending, and conducted two nation-wide inspections to root out illegal local government borrowing.

But while all this activity demonstrates Beijing’s resolve, the constant escalation is also a sign of the central government’s failure to get the situation under control. China’s campaign has not been without successes. Most notably, financially fragile government financing vehicles are finding it harder to borrow. Still, to get around credit tightening in traditional avenues, local officials have continued to invent new loopholes that allow them to bypass the debt ceiling. Public-private partnerships (PPP)—a way of getting the private sector more heavily involved in funding infrastructure construction—were once heralded by Beijing as a way to build infrastructure without government debt. But in recent weeks the Ministry of Finance has acknowledged that PPPs have become a way for local governments to simply disguise their borrowing.

A less well publicized example is that local authorities have also become creative with government procurement processes.

Like PPPs, Beijing was initially keen to encourage local governments to procure more goods and services from the private sector. However, China’s local governments have broadened the scope of government procurement, and now use it to finance everything from infrastructure construction to government investment funds.

In a case representative of the abuses, recently publicized by China’s Ministry of Finance, the provincial government of Inner Mongolia signed a “procurement contract” with a construction company to build a highway, promising to pay for the project in installments spread over two decades. The construction company then used the contract to borrow money from banks. The ministry’s concern is that the only difference between repaying a bank loan in installments and making similar payments to a construction company is the accounting; the latter allows local authorities to keep future liabilities separate from debt figures.

The problem of imprudent local finance is not unique to China. Regardless of the country or political system, checks and balances are required to ensure that public money is not squandered. In open societies, those checks are bottom up: the public and the courts have the authority to punish officials for their borrowing and spending decisions. In China, oversight is top down, and Beijing is betting on greater central government scrutiny to solve its problems. Here is a case in point: Beijing recently tried to curb procurement abuses by publishing a detailed list of things local governments cannot purchase through government procurement processes.

Ultimately, the experience of the last few years suggests that the top-down approach is unlikely to fundamentally fix China’s local government debt problem. As long has local governments have discretion over spending—which is necessary in a country as large and diverse as China—the best Beijing can do is retrospectively close loopholes. Greater public participation in the budgetary process is necessary if local governments are to spend public money wisely, something Beijing has repeatedly promised, but no real progress has been made in recent years.

In the meantime, the true size of government debt will remain hard to measure and prone to manipulation. Beijing is trapped: it wants to impose fiscal rectitude, but is unwilling to experiment with public oversight in order to achieve it.

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