China’s debt rift is hurting its economy

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In 1975, in what became the eulogy of his long and tumultuous career, Zhou Enlai, the first Premier of the People’s Republic of China, proudly announced that his government was free of all debt. „Contrary to the economic turmoil and inflation in the capitalist world, we in the National People’s Congress maintain a balance between our national revenue and expenditure and do not contract external or internal debts,” he said.

Nearly half a century later, that attitude is still written on the hearts of Finance Ministry officials in Beijing. China’s central government debt has hovered around 24 percent of GDP, low by global standards, and the leadership has been reluctant to let it rise. Yet by contrast, the debts of China’s local governments are huge — 93 percent of GDP according to IMF figures, which is probably an underestimate — and rising. This division between central and local governments, with one in control but not in charge of the other, underlies China’s economic challenges today.

A fundamental fact about China’s financial system is that local governments make up almost all of the expenditures, but rely on the center for revenue more than anywhere else in the world. In addition to obvious local duties such as roads, parks and garbage collection, local authorities bear most of the responsibility for education, health, social security and housing, and account for 85 percent of total government spending. They directly collect only 55 percent of the government’s revenue. The system is balanced by shifting from the center to the regions.

In a large country like China, there are qualifications to provide close results to the people, but the mismatch between revenue and expenditure creates many problems. For example, the lower the governance pyramid is, the more starved the system is of resources, as each layer – province, province, district – tends to hold back what it needs before sending money down the chain. Implementation of the central government’s spending plans has been inconsistent. Meanwhile, local government officials, who must provide growth to climb the bureaucratic ranks, are doing everything they can to find the money.

China’s property boom has been driven in part by local governments relying on land sales for revenue. Borrowing off the books, known as local government financing vehicles, is a way to deal with revenue constraints and financial infrastructure. There are many reports of land sales collapsing due to the housing recession and the federal government barring local borrowing, municipalities facing fines and penalties, launching retroactive tax investigations or not paying employees on time as they struggle to balance their books. . None of this bodes well for the struggling private sector.

Beijing knows all about these structural problems and has long wanted to fix them. Indeed, when Xi Jinping first came to power in 2012, fiscal reform was a big part of his domestic policy agenda. For example, one of the reasons local governments are struggling is the success of reforms to budget management and financial management, which moved issues off the books and made it harder to write them off.

As is typical for Xi, the central government is unwilling to surrender control. It often specifies the services that local governments should provide, but refuses to hand over the revenue sources that fund them. Reluctance to take on large new expenditure liabilities in the central books. It has reduced local government debt, still true to Zhou’s wishes, instead refusing to allow central government debt to increase. The result has been de facto fiscal tightening over the past few years, even as the economy has struggled to recover post-Covid.

At the recent „Third Plenum”, a crucial meeting on economic policy held every five years, Beijing promised to change this. It said it would give local governments more control over taxes and increase financial transfers from the centre. It will consider converting various local surcharges into a single local tax. It would shift responsibility for consumption tax from manufacturers to retailers and allow local governments to collect it, an important reform. If the central government has more fiscal power, it will „increase the proportion of central government expenditure accordingly”.

This is what is needed. Yet China has set a similar course in the past, amid long debates over whether to introduce property taxes as a natural way for local governments to fund local spending. If Beijing is really going to implement these plans, it will have to give up some control and accept an increase in central government debt if it is to revive the stagnant economy.

In his 1975 speech, Cho made several other announcements. „We must strongly support the centralized leadership of the party,” he said. „We must work hard, build the nation and conduct all enterprises with diligence and frugality.” Focus and Frugality: It is not an easy habit to give up, therein lies the challenge.

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