Abstract: The paper explained four issues to help understand China's fiscal health. First, local government debt risks lie in liquidity instead of solvency. Second, China's investment efficiency remains high relative to other countries, with ample room for infrastructure investment. Third, the issue with government debt is not the scale but the structure. It is necessary to optimize the allocation of expenditure responsibilities between the central and local governments and change the financing model for local infrastructure construction. Fourth, land finance has a special historical role in the national economic cycle, and the transformation of local finance is not only to find new sources of revenue but also to think from the perspective of the national economic cycle.
Recently, China’s massive local government debt has received widespread attention, and the discussion on local government debt tends to lead to the assessment of the government’s fiscal condition. Over the past years, the government’s capacity to increase income has been curbed due to tax- and fee-cut policy, the economic downturn, and the slide in the real estate market. Against this background, there are growing concerns about fiscal deficit and debt risks.
Is there any solvency risk of local government debt? Is it necessary for China to raise debt to promote infrastructure development? What are the problems in the previous buildup of local government debt? What are the implications of the radical change in the land market? These issues cannot be answered separately but should be systematically observed and addressed based on China's unique conditions and specific developmental stage.
I. THE RISKS OF LOCAL GOVERNMENT DEBT LIE IN LIQUIDITY INSTEAD OF SOLVENCY.
The public concern about government debt risk is not hard to understand because Chinese people only gained firsthand knowledge of debt after the commodification of housing, which has been only over 20 years. Moreover, the Chinese government accumulated debt only a decade earlier than ordinary citizens.
In 1981, after "no internal or external debt" for 23 years (1958-1980), China resumed the issuance of national bonds. Initially, "everyone thought China was forced to issue bonds in 1981, and there would be no second time" (Gao Jian, 2009). But surprisingly, since then, like most countries, China's government debt has never stopped growing - national bonds have been continuously issued; local government financing vehicles took on most of the government's function in the construction and issued a lot of debt after the "Wuhu model" in 1998, creating implicit government debt; in 2014, governments at the provincial level were allowed to issue local government bonds autonomously.
By the end of 2022, the Chinese government had an explicit accumulative debt of 60 trillion yuan (25 trillion central government debt and 35 trillion local government debt). Local government financing vehicles (LGFV), closely related to the government, hold an interest-bearing debt balance of nearly 60 trillion yuan. According to the IMF’s estimated ratio (two-thirds of LGFVs as implicit government debt), 40 trillion yuan can be considered implicit government debt.
Overall, China’s general government debt has grown from zero to 100 trillion yuan in just 40 years, which naturally caused concerns about debt risk. The risk of local government debt received the greatest attention because 75 trillion yuan of government debt is local debt.
However, from an asset-liability perspective, local government debt does not pose a solvency risk; liquidity risk is the main problem. China is a socialist country with public ownership as the mainstay. At all levels of local governments, while they have liabilities, they also hold state-owned assets at a greater scale.
According to the Comprehensive Report on the Management of State-owned Assets in 2021 by the State Council, as of the end of 2021, local non-financial state-owned enterprises had total assets of 206 trillion yuan and total debt of 130 trillion yuan (including local government financing vehicle debt). The overall debt-to-asset ratio was 62.8%, which is a healthy level. If non-financial central state-owned enterprises and national administrative and public state-owned assets were included, the total non-financial state-owned assets in the country would exceed 360 trillion yuan. If the government's responsibility for repaying local government financing vehicle debt is considered when calculating government debt, then it is also necessary to consider the government's actual control over state-owned assets when evaluating solvency.
There are mainly five models to solve local debt risk through stated-owned assets:
1. A direct model of “renting out and selling the assets”;
2. A "debt for equity swap" model introduces asset management companies (AMC) as the shareholders. After solving the debt issue, the agency can exit through equity repurchase from indebted state-owned companies and indebted shareholders or equity sale to a third party;
3. A model of stated-owned debtors “selling equity to repay the debt,” which mainly occurs within the state-owned system. For example, Guizhou Expressway Group sold equity to Moutai Group;
4. A model of refinancing or debt extension through negotiating with state-owned financial institutions to repay the debt;
5. A model of asset securitization, mainly including asset-backed securities (ABS) and real estate investment trusts (REITs)
Among these models, the first two posed concerns about the loss of state-owned assets. “Selling equity to repay the debt” and negotiating with financial institutions to extend debt repayment would also lead to moral hazard and financial risks. Moreover, as asset-backed securities (ABS) are essentially bonds, local state-owned enterprises are restricted from issuing ABS.
In terms of REITs, this new finance model for infrastructure, which was put a lot of expectations, also faces challenges (Wu Tao et al., 2021). First, companies usually do not fully own the underlying assets in China’s infrastructure projects. The original equity holders are short of effective underlying assets to issue REITs. Second, most of the infrastructure projects cannot meet the liquidity requirement; third, there is a problem of double taxation.
Given the concerns and restraints mentioned above, local governments are unable to easily mobilize the massive state-owned assets to reduce debt risks. Therefore, the risks of local government debt mainly lie in the lack of liquidity of state-owned assets.
To address these issues, we should improve local infrastructure financing models based on the reform of state-owned enterprises (SOEs). In terms of resolving the risks of hidden debt, the reform of SOEs should spin off public welfare projects of LGFV（local government financing vehicle) and promote market-oriented reform; local governments should employ various tools to resolve debt arising from public welfare projects. At the same time, LGFVs（local government financing vehicles) should be repositioned as average SOEs to participate in the market competition on an equal footing with other market players.
Building on deepening state-owned enterprise reform, we should explore new financing models for local infrastructure investment. Public welfare projects that lack cash flow should receive funding directly from government credit. Meanwhile, projects with certain cash flows can obtain funds through asset securitization, such as REITs. This requires the provision of high-quality underlying assets for REITs issuance and adjusting tax policy to address issues of double taxation and tax burden on REITs issuance.
II. CHINA’S INVESTMENT EFFICIENCY REMAINS HIGH RELATIVE TO OTHER COUNTRIES, WITH AMPLE ROOM FOR INFRASTRUCTURE INVESTMENT.
Most of the local government debt comes from the financing demands of infrastructure investment. Some argue that China’s investment efficiency is declining, and infrastructure construction might reach saturation, so we should not and need not keep strengthening infrastructure investment to bolster economic growth.
However, there is still ample room for infrastructure investment in China. According to Statista's statistics, as of 2021, the Chinese mainland had 248 civil airports in traditional transportation infrastructure, while in 2020, the United States had 5,217 public airports (plus 14,702 private airports). Although China has made great progress in high-speed railway construction in recent years, data from the "International Statistical Yearbook (2021)" shows that in 2019, China's total railway mileage was 68,000 kilometers. In contrast, the United States railway mileage was as high as 150,000 kilometers. In 2019, China's total road mileage was 5.01 million kilometers, while the United States was 6.64 million kilometers during the same period. In other words, although China has more than four times the population of the United States and a comparable land area, the mileage of China's roads, railways, and the number of airports is only 75%, less than 50%, and less than 10% of those in the United States, respectively.
There is still room for improvement in municipal infrastructure construction. Shortages of parking lots and urban waterlogging are common problems in many cities, and the construction of parking lots, road planning, and underground pipe galleries are needed to address these issues. In addition, "new infrastructure," such as information services and new energy businesses, still needs improvement, which is crucial for innovation and upgrading.
In general, China's per capita capital stock is significantly lower than the United States, and there is ample room for improving investment efficiency. In particular, if the spatial allocation of infrastructure investment is optimized, the efficiency of infrastructure investment can be further enhanced. Scholars such as Liu Shangxi and Lu Ming have proposed adjusting the direction of infrastructure investment based on population mobility. It is suggested to strengthen infrastructure investment in urban and city clusters with population inflow and be more cautious in incremental investment in regions with population outflow to avoid wasteful investment.
Certainly, there are also critiques of China's declining investment efficiency trend based on macro data. However, in reality, we have been overly fixated on the decline in investment efficiency from a vertical standpoint. Compared horizontally with other countries, China's investment efficiency is still relatively high.
The efficiency of investment can be measured by the Incremental Capital Output Ratio (ICOR), which indicates how many units of investment are required to produce one unit of GDP. The lower the value of this indicator, the higher the investment efficiency. Over the past decade, China's ICOR has continued to rise, indicating a decline in investment efficiency. However, John Ross calculated a five-year moving average. He found that China's ICOR is lower than the average of both developed and developing countries, as well as the world average. This suggests that China's investment efficiency is still at a relatively high level on a global scale. We have replicated Ross’ method and obtained slightly different results, but they generally confirm his observations.
Ⅲ. THE PROBLEM WITH GOVERNMENT DEBT IS ITS STRUCTURE INSTEAD OF ITS SCALE. CHINA SHOULD OPTIMIZE THE EXPENDITURE RESPONSIBILITIES OF THE CENTRAL AND LOCAL GOVERNMENTS AND CHANGE THE FINANCING MODEL FOR LOCAL INFRASTRUCTURE CONSTRUCTION.
The fundamental reason local governments in China have accumulated a large amount of implicit debt is that they are responsible for many tasks, such as safeguarding people's livelihoods, ensuring the operation of the government, and maintaining stable economic growth, which approaches infinite liability. Budgetary revenues, including transfer payments, are already stretched to their limits to ensure people's livelihoods and the government's operation. Local governments must borrow through urban investment companies when they need to promote infrastructure construction for economic growth and public goods..
Currently, the main body of infrastructure construction has shifted from traditional "railways, highways, and airports" to public facility management services, mainly for urban municipalities. This means that the potential financial benefits of infrastructure projects are shrinking. Therefore, the most important characteristic of China's infrastructure investment financing structure is that the low-yield (or even non-yield) and high public goods nature of infrastructure construction, which lacks cash flow, is excessively reliant on high-cost market-oriented funds (Sheng Zhongming, Yu Yongding, and Zhang Ming, 2022).
This mismatch between revenue and cost of financing structure has brought about two results:
1. The higher use of more expensive funding sources increases the cost of infrastructure financing. From the perspective of debt financing for infrastructure, it can be ranked in order of the scale of the funds used, including national bonds, local general bonds, local special bonds, enterprise self-financed urban investment bonds, and bank loans. However, the costs of these financing sources generally increase step-by-step.
2. While nominal government debt is stabilized, the general debt level increases. The above financing structure reduces the ratio of national and local government explicit debt/GDP, thus reducing the explicit fiscal risks of the government. However, it increases the ratio of general local government debt to GDP, which increases the fiscal risks of local governments. This financing structure shifts the fiscal and financial risks of expansionary fiscal policies from the central to local governments, but as a whole, China's economic, fiscal, and related financial risks do not decrease. On the contrary, due to the complexity, opacity, and rising costs of funds and management associated with this financing structure, the fiscal and related financial risks brought about by China's expansionary fiscal policy may have increased instead of decreased.
To address these issues, the key is to optimize the central and local governments’ expenditure responsibility and improve the infrastructure investment financing structure. Specifically, it is necessary to increase the proportion of the general public budget, particularly the central government's general public budget, in infrastructure investment financing. In terms of debt, it requires increasing the direct support of explicit government debt, particularly national debt, to infrastructure investment. To achieve this, it is necessary to increase the issuance scale of national and local government bonds, focusing on national debt due to the fiscal pressure local governments face.
Investors in the bond market perceive little difference between national and local government bonds as the overall credit of the country backs them, and China's national debt market is not yet sufficiently developed. Therefore, increasing national debt issuance would not only promote infrastructure investment but also deepen China's national debt market.
Ⅳ. LAND FINANCE HAS PLAYED A SPECIAL ROLE IN THE NATIONAL ECONOMIC CYCLE. THE TRANSFORMATION OF LOCAL GOVERNMENT FINANCE IS NOT ONLY ABOUT FINDING NEW SOURCES OF REVENUE BUT ALSO CONSIDERING IT FROM THE PERSPECTIVE OF THE NATIONAL ECONOMIC CYCLE.
"Land finance" has played an important role in China's economic development over the past two decades. It can be observed from the fiscal revenue and expenditure perspective, but its special historical role needs to be explored in the national economic cycle.
From the perspective of fiscal revenue and expenditure, almost 40% of the government's comprehensive financial resources come directly from the real estate industry. In 2020, the real estate industry contributed 2.5 trillion yuan in taxes, and the tax revenue of the housing and construction industry was 339.6 billion yuan. The estimated land transfer income from real estate development (residential + commercial land) in 2020 was 7.9 trillion yuan. The total tax revenue and land transfer income from real estate amounted to nearly 11 trillion yuan, and the direct financial contribution of the real estate industry (its proportion in total revenue of the general public and government funds) was 38.8% in 2020.
From the perspective of the national economic cycle, land finance has leveraged the conversion and circulation of national savings into investment. In the past, it played an important role in converting national savings into infrastructure investment and became an important economic cycle for China's rapid development at a certain stage. This process is specifically reflected in the parallel operations of the state ownership of land and the market transfer of land use rights, which enable the government to control the value of the land. The continuous entry of residents' savings into the real estate sector during urbanization makes land values stable and expected to appreciate. Therefore, based on government land capital injection, urban investment companies can leverage multiple or even tens of times debt funds for infrastructure construction, driving urban development, credit expansion, and economic growth.
However, as the real estate market has bottomed out rapidly in the past two years, land revenue has sharply declined, and the expected value of land has weakened. The above-mentioned model will face great challenges. At this time, the financial transformation of local governments is not only to find new sources of revenue other than land transfer but also to explore a new model to replace or partially replace the critical role of "land finance" in the national economic cycle.
When thinking about the transformation of local finances from the perspective of the national economic cycle, the key is to understand the different functional positioning of local governments in different stages of economic development. As China is about to enter high-income countries, local governments should pay more attention to consumption expenditures and increase support for people's livelihoods, education, and basic scientific and technological innovation. From the launch of the reform and opening up to the early 21st century, China mainly faced the problem of insufficient investment. Therefore, infrastructure construction is a big task for local governments to promote economic growth and lay the foundation for increased investment in various markets. Therefore, local governments need to rely on comprehensive financing of land transfer income and stock land value for construction.
Nowadays, China's total economic output and per capita development level have both increased significantly. High-quality economic development and the public's expectations of a better life all point to the need for consumption to play a greater role in economic growth. The ultimate social consumption is composed of both household and public consumption, and there is a positive correlation between household consumption and public consumption, such as social security, education, and medical care. The growth of public consumption represents an improvement in the quality of public services. The income gap can be reduced by equalizing education and medical insurance, and the soundness of social security will also raise income expectations, promoting household consumption. In addition, the government's expenditure in the education and scientific innovation sectors is also the foundation for scientific and technological potential and the new driver for economic growth.
When the government pays more attention to the role of consumption, the demand for investment directly promoted by land value will weaken. After boosting household consumption and scientific and technological strength through public consumption, it will be easier to stimulate market-driven investment demand and promote a virtuous cycle of the national economy.
Of course, local finance should shift to more reliance on consumption than investment, which is also a gradual evolution. As mentioned, there remains huge space for infrastructure investment and improvement of investment efficiency in China. However, from the perspective of balanced economic structure development and smooth circulation of the national economy, finance also needs to consider and handle the relationship between investment and consumption. Consumption and investment are not contradictory. Consumption is the purpose of investment, and it is the right thing to do to satisfy the increasing need for a better life among people. Especially, consumption in education and medical care is a process of accumulating human capital. We need to break the opposition between consumption and investment, see more dialectical unity between them, and think about the transformation of local finance from the perspective of the smooth circulation of the national economy.
The article is translated by CF40 and has not been reviewed by the authors. The views expressed herewith are the author’s own and do not represent those of CF40 or other organizations.
