Fiscal

As part of fiscal reforms that launched in 2014, local governments were significantly restricted in their borrowing. The only way localities could continue borrowing was by issuing debt, as Beijing sought to put a lid on off-budget borrowing. This would involve a radical change in local government behavior that, unsurprisingly, did not sit well with local officials.

It didn’t take long for local officials to “discover” new and inventive ways to continue borrowing off-budget—one of the vehicles was through the government procurement process. For example, local governments can finance multi-year construction projects under the guise of government procurement, only documenting current expenses and concealing future debt from the budget.

To close this significant loophole, Beijing issued a long and very detailed list of activities that local governments must not finance through government procurement. Some items on the list, such as urban renewal projects, were previously allowed but could be left unfinished once this list takes effect. Not surprisingly, the central government exempted its priorities, such as shantytown renovations and poverty alleviation, from the list of prohibited activities.

While Beijing reiterated the need for transparent disclosure of all government procurement contracts online, it also ordered banks to step up their scrutiny of loans to government procurement contractors. But whether such a top-down approach can discipline local financing behavior remains an outstanding question.

Beijing has set a deadline at the end of July 2017 for provincial governments to rectify all unlawful financing practices. After the deadline, noncompliant local governments will be punished according to previously issued documents on local government debt. In other words, this measure is about strictly implementing existing regulations, and the Ministry of Finance will closely supervise local government progress.

To transform LGFVs into independent enterprises, local governments should never intervene in LGFVs daily management or guarantee LGFV borrowing. In addition, local governments are prohibited from transferring public assets and land to LGFVs, guaranteeing debt repayments, or doing favors for financial institutions in exchange for providing credit to LGFVs. Meanwhile, LGFVs are required to inform their creditors that they are no longer backed by local governments, which are not liable for any post-2014 LGFV borrowing.

Another area that concerns Beijing is the public-private partnerships, despite the fact that it is officially promoting such a financing model. The policy reemphasizes that private capital should share both profit and loss with local governments, and the latter is prohibited from promising minimum returns or principal repayments to private investors.

This marks the first time all key economic and finance agencies are collaborating on addressing illicit local government borrowing and clamping down on LGFVs. The six agencies will join forces in tracking local governments’ debt issuance to patch up loopholes and prevent illegal borrowing, including setting up a platform to monitor government spending and LGFV debt issuance.

Finally, any entity found to be involved in illegal lending to local governments, including intermediaries such as investment banks, as well as accounting and law firms, will be duly punished for their complicity in such activities.

Setting a debt ceiling will not be a one-size-fits-all measure, but will account for regional variation and include different criteria. As such, the central government will reward a higher debt ceiling to low risk, fiscally sound provinces that are more capable of debt management.

Moreover, local governments’ investment project needs will also be taken into consideration when setting a debt ceiling. For instance, provinces and regions involved in major initiatives such as the “Belt and Road,” shanty town renovations, and agricultural reforms will likely have more flexibility in the debt ceiling. Still, Beijing will ensure that no province has debt growth that is significantly higher than the national average in any given year.

As part of the “no bailout” policy for local governments, the central government thought it necessary to prepare for contingencies as a precaution. So it issued guidelines that define four types of “debt risk events” of varying severity and outlines corresponding responses, as well as imposing tighter controls on local government debt issuance.

A Grade I debt risk event, the severest of the four, takes place when a provincial government completely defaults on bond payments or when more than 15% of the counties have difficulty with debt repayment (provincial government is responsible for bailing out county governments). The other less severe risk events are characterized by a lower percentage of county government defaults within a province.

Beijing has stressed that local governments need to take full responsibility for repayments, implying that local government should marshal whatever resources are necessary—including cutting spending, tapping government funds such as revenue generated by state-owned properties and stabilization funds, selling assets, and adjusting budgets—to head off a potential debt crisis. Regions considered fiscally risky will not be allowed to make any new investments from their budget until debt consolidation is completed.

City and county governments are obligated to consolidate their fiscal budgets if the annual general debt payments exceed 10% of public spending or if payments on specific purpose debt exceed 10% of the local government fund budgets. When consolidating budgets, local governments should collect overdue taxes and outstanding fees, impose fiscal austerity, and sell state-owned assets if necessary. Although technically illegal under the new budget law, Beijing will make some exceptions for local governments to honor previous guarantees for lending to local state-owned enterprises to address legacy debt issues.

The provincial government is responsible for ensuring lower-level government enforcement of these measures and for bailing out lower-level governments when these actions fail. When even a provincial government has difficulty to repay debt, the central government will extend a temporary loan. Although the loan will eventually need to be repaid, the fact that the central government is willing to do so does weaken its “no bailout” pledge. However, Beijing has promised that it will investigate and hold local government officials accountable for violating laws and the contingencies stipulated.

Rules on managing specific purpose debt are identical to general purpose bonds except when it comes to repayment. Debt accrued for a specific project must be repaid with the government managed fund and with revenue generated from that project. This means local governments and investors need to have confidence in the project’s cash-generating potential.

The Ministry of Finance mandates that all proceeds from local debt issuance should be spent on public goods and capital expenditure but not on local governments’ day-to-day operation expenses.

In addition, the principal should be paid back by drawing from the budgetary revenue or by issuing new bonds. Interest payments, on the other hand, must be paid back by only drawing from the budgetary revenue.

Finally, since city and county governments cannot issue debts on their own, they must sign debt transfer agreements with provincial governments. Provincial governments should be fully transparent in this process, making publicly available information on public budgetary revenue, plans for bonds issuance, usage of proceeds, and funding for debt repayments.

Rules on managing specific-purpose debt are identical to general purpose bonds except when it comes to repayment. Debt accrued for a specific project must be repaid with the government managed fund and with revenue generated from that project. This means local governments and investors need to have confidence in the project’s cash-generating potential.

The suboptimal division of government authority at every level of China’s  political system has been a longstanding challenge to overall governance. This sort of “federalism with Chinese characteristics” leads to, among other things, rampant overlap between local and central government responsibilities.

For instance, providing public security and public transportation services is local in nature, and efficient management of these services requires specific and deep local knowledge beyond the central government’s capacity. On the other hand, national defense and ensuring a well-functioning inter-provincial commerce system that benefit the entire economy clearly falls under the remit of the central government.

Yet such division remains muddied. So this five-year plan (2016-2020) proposes to fix all the existing issues of administrative overlap and redundant authority. It calls for the centralization of all national issues that ought to be handled by Beijing, while issues and services that require extensive local knowledge will be handled by the local government. Beijing will have the authority to redefine administrative and taxation responsibilities of local governments.

Within a province, administrative responsibilities will also be reassigned among various levels of government, though the plan is vague on how taxation authority would align or be redistributed between central and local governments. The central government does, however, intend to spend more on inter-regional fiscal redistribution, especially focusing on boosting public services in less developed regions.

Finally, the plan emphasizes that there will be no major change to the distribution of fiscal revenue between central and local governments, implying that Beijing still views fiscal power as the ultimate control over provinces. In reality, however, a large portion of central revenue will be eventually transferred back to provinces as part of the fiscal redistribution reforms that Beijing has already outlined.

Initiated in 2010, resource taxes on six commodities, including oil, natural gas, and coal, were changed from volume-based to ad valorem. Now, the ad valorem resource tax has been expanded to cover most commodities and minerals such as iron ore, copper and gold. The benefit of an ad valorem tax is that tax burden increase as price rises, thus encouraging resource conservation through reducing demand. At the same time, all existing fees related to natural and energy resources will be eliminated by October 2016, meaning that on balance, producers will not see significant tax increases as a result of this reform.

Local governments, who will collect all revenue from the resource tax, will have some autonomy in determining the tax rates, so long as they fall within ranges set by the Ministry of Finance. For instance, to encourage resource conservation, minerals extracted from low-grade ore or other waste mineral products will enjoy a lower tax rate to be determined by the provincial government. Beijing also plans to eventually expand the scope of the tax to cover water, forests, and grasslands, none of which is currently subject to this tax.

Starting in July 2016, Hebei province will levy taxes on surface water and underground water usage, including for electricity generation purposes. This new tax will replace the existing water resource fee. Hebei was selected as the first test case for this tax because it faces some of the most severe water shortage and over-extraction problems in China. Moreover, 90% of the revenue from this tax is meant to go to local government coffers.

The quantity-based tax rate may vary within the province and across industries. The minimum tax on ground water usage is ¥0.40 ($0.06) per cubic meter and ¥1.50 ($0.22) for underground water. And the rate will progressively increase depending on the degree of over-extraction in the region.

Water-intensive industries, including car washes, bath houses, golfing, and skiing will be charged higher rates to curb consumption. Recycled water, as well as agriculture-related water usage below a certain amount, will be exempt from this tax. Except for water-intensive industries, the vast majority of sectors is not expected to experience added tax burden.

The VAT has several advantages relative to a business tax. First, it encourages outsourcing and specialization because under a VAT, those business expenses would be tax-deductible. Second, it reduces the likelihood of tax evasion. By definition, VAT is imposed only on value-added—that is, the difference between revenue and cost. Since firms need to present invoice for all expenses, they have the incentive to ask their suppliers for invoices, which is a tax payment certificate. Third, Beijing also plans to simplify the tax code and reduce the tax burden.

China has been experimenting with VAT reform in certain locations and industries, and plans to go national with these reforms by May 2016. Previously, the VAT only applied to firms that produce goods—for example, the manufacturing sector. At the same time, the services industry was subject to a business tax, which was levied as a percentage of corporate revenue rather than based on value-added.

This reform will have a significant impact on certain sectors such as financial services because substantial changes in the tax code will accompany it. Business practices will need to adapt, especially in affected industries. However, the overall tax burden should not increase as a result of this change, according to the central government. It has estimated that the burden will actually be reduced for the majority of businesses relative to what they paid in taxes under the previous regime.

The central government will assign an annual debt ceiling for each province, while the provincial government will accordingly determine the ceiling for the next level government below. The first ceiling was set based on the debt level at year-end 2014 plus the projected 2015 fiscal deficit.

All outstanding off-balance sheet debt will be re-classified as either local government debt or contingent debt. Existing illegal government borrowing or guarantees will be renegotiated to clarify and reduce government liabilities.

In the next three years, all existing local government debt will be refinanced through bond issuance, which translates into new bond issuance of roughly ¥5 trillion ($750 billion) per year. As such a large volume of new bond issuance will surely drain market liquidity, the Chinese central bank, banking regulator, and the Ministry of Finance will coordinate bond issuance to avoid potential negative impacts on financial markets. Since existing local government borrowing has much higher interest rates than government bonds, swapping that debt for bonds should also significantly cut debt servicing costs.

The majority of PPP projects in China involves infrastructure and public utilities, which take the form of concessions. In a bid to promote the PPP model and attract participants, Beijing has provided details regulating infrastructure and public utilities concessions.

Private companies can now enter into agreements with local governments, via a competitive bidding process, to invest in, construct, and operate infrastructure and public utility projects within a given period. Investors are encouraged to finance the PPP projects through equity and bond issuance, for which they will receive preferable treatment. They can also borrow from policy banks at cheaper rates and with longer maturities of up to 30 years for financing qualified PPP projects.

Local governments, on the other hand, are allowed to participate in PPP projects through establishing special funds in conjunction with banks and providing subsidies for the projects. Since one purpose of the PPP model is to spread the risk between the private and public sectors, local governments cannot guarantee returns on any PPP project.

Concession projects can take three forms: build-operate-transfer, build-own-operate-transfer, and build-transfer-operate. The contract terms are based on factors such as the demand level and the project’s payback period and should normally not exceed 30 years, though exceptions are made for very large investments.

After the contract expires, companies must hand over the projects to local governments. Meanwhile, local governments are also responsible for creating a “Plan B” to continuously supply public goods and services in the event that contractual obligations for specific PPP projects are not met.

This type of bond, as implied by its name, is used to finance specific projects, usually infrastructure projects or highways that generate revenue. One key distinction is that specific bonds will be repaid primarily from revenue earned from the specific project.

Since most infrastructure investments do not generate immediate cash flow, local governments can issue long-term bonds. Similar to the general purpose bond, local governments can issue specific purpose bonds with varying maturities. But in any given year, newly issued specific purpose bonds with 7- and 10-year maturities cannot exceed 50% of the total amount.

Provincial and municipal governments can now issue general purpose bonds as book-entry securities with fixed coupon rates, according to these detailed measures. The bonds can be issued with maturities of one, three, five, seven, or ten years. The Ministry of Finance has emphasized that proceeds from the bonds should be spent only on social welfare programs that do not generate revenue.

To level annual debt repayments, in any given year, bonds issued with the same maturity cannot exceed 30% of the total amount of bonds. Local governments can determine bond interest rates directly with their underwriters or through auctions where local governments take the lowest bid from underwriters.

Meanwhile, bond yields will be set based on the most recent five-day average of sovereign yields of the same maturity plus a small premium. Specifically, local government bond yields is not allowed to be lower than sovereign yields to ban collusion between local government and its creditors.

Employees in the state sector have long enjoyed a very generous pension plan that had much better benefits compared to pension plans in the private sector—a legacy of the “iron rice bowl.” But as China undergoes a fairly rapid demographic transition to an older society, the current state pension system is becoming increasingly unaffordable.

To alleviate future fiscal burdens, and with the goal of eventually consolidating fragmented pension plans, Beijing has decided to replace the current state pension plan with one that approximates the private sector’s. The new system is a combination of pay-as-you-go and portable personal pension account, which means state employees will now have to personally contribute to their pension plans.

Under the new plan, employers will pay 20% of total salary as the basic insurance fee and employees will deposit 8% of their salaries in their personal pension accounts. In addition, an occupational annuity system equivalent to 12% of salary will be established by the employers to complement the pension system. Pension benefits will depend on both local average salary and the amount of assets accumulated in the personal account.

If this new policy is strictly enforced, civil servants’ pension benefits will converge with that of the private sector, and should further reduce the amount of unfunded pension liabilities. To ensure a smooth transition, Beijing pledges that the new plan will not be retroactively enacted, so current retirees won’t be affected. Moreover, current state employees will receive additional compensation, but all new state employees will be subject to the full extent of the plan.

Currently, there are two types of central-to-local transfer payments: general purpose and specific purpose transfers. Local governments have considerably more discretion in spending general purpose transfers, whereas specific transfers spending, such as funding for a particular infrastructure project, is more restricted.

As part of the reform, the central government will raise general transfers as a proportion of total transfers to over 60% (it was raised from 53% in 2012 to 58% in 2014). Beijing hopes that by bolstering these transfers, it can help equalize the inter-regional gap in providing basic public services, including for border regions and provinces that have urbanized more migrant workers.

Meanwhile, local no longer needs to provide match funding for the majority of specific transfers. Previously, local government is required to contribute match funding for all specific transfer it received, which sometimes forces local government to engage in off-budget borrow. From now on, local governments are only required to provide match funding for projects in which central and local governments are jointly responsible, such as compulsory education, healthcare, social security and employment, and environmental protection.

For decades, local governments have been offering various preferential taxes and other favorable policies to attract investment and bolster local economic development. Such policies, however, can stifle competition and encourage protectionism as local governments had the power to dole out subsidies to their pet enterprises and industries. Moreover, some of the local incentives and subsidies are not necessarily in compliance with China’s World Trade Organization accession agreements.

With this latest policy, the central government aims to take away some of the power of local governments for setting economic incentives, which can often be arbitrary. In particular, local governments should no longer exempt companies, domestic or foreign, from paying government administration fees or contributing to state managed funds and social security, unless specifically stipulated by laws. In addition, local governments are prohibited from transferring state assets to companies on the cheap, such as land, as a form of subsidy.

Local governments will now be able to issue bonds, but any other way of raising financing, particularly through the local government financing vehicles (LGFVs), will be illegal. In fact, the plan mandates existing LGFVs to either shut down or become independent business entities.

All local government off-budget borrowing will be reviewed by fiscal and auditing authorities to clarify the exact amount of local government debt. Once determined, the debt can be refinanced through the issuing of new bonds. This should theoretically save local governments billions as the bonds will be priced close to sovereign yield, which will be significantly lower than the interest rate on existing debt.

In addition, a ceiling will be set on the local government debt level, and, to avoid soft budget constraints, Beijing has made it clear that it does not intend to bail out local governments that default on their debt. Instead, provincial governments will now be responsible for monitoring and bailing out lower-level governments.

With this first amendment to the Budget Law in two decades, Beijing takes aim at increasing transparency in local budgets and holding local government more accountable. This reform plan marks the central government’s most dramatic effort to date to make China’s local debt problem manageable. The revisions strengthen budget management by requiring “full-scope budgeting,” which means that all local government revenue and expenditure must be included in budget reports. Specifically, the full-scope budget is divided into several components: a general public budget, a budget for state managed funds, a budget for state-owned capital operations, and a budget for the social security funds.

Previously, local governments, in principle, should have balanced budgets and, except in rare cases, they were not allowed to issue bonds or borrow from banks. That is, local governments theoretically relied almost exclusively on local tax revenue and fiscal transfers from the center to support local economic development. In reality, however, local governments have been borrowing heavily to stimulate the economy after the global financial crisis. They often engaged in off-balance sheet financing through the so-called “local government financing vehicles” with little transparency. These behaviors and “local innovations” made it very difficult for Beijing to monitor and control how much local governments have borrowed.

To eliminate off-budget borrowing, provincial governments will be allowed to issue bonds for the first time as a new, and only, way to raise debt levels. In addition, the law requires local governments to establish multi-year budget balancing mechanisms, by setting up budget stabilization and adjustment funds. The revised law will also devolve more oversight authority to local people’s congresses, giving them more power to audit and approve budget plans, with particular attention paid to transfer payments, budget execution, and spending on government operations and administrative purchases.

The central government is urging local governments and state-backed organizations to outsource certain public services to private entities and non-government organizations and expects to have a national procurement system for services in place by 2020. Local governments are required to make public procurement lists of social services and select their contractors through a competitive bidding process.

The service providers’ performances will be evaluated, with their results publicized to help inform the selection of future contractors. The central government expects that by relying more on market mechanisms in the bidding process, the new system will lower costs and improve the efficiency and quality of public services.