Sara Hsu
Sara Hsu

China´s is setting up five asset management companies or bad banks to buy up bad debts on a local level, comparable to five national firms that bailed out China´s largest banks in the 1990s. But that will not help, if the current fiscal dilemmas for local governments are not solved, writes financial analyst Sara Hsu in the Diplomat.

Sara Hsu:

The problem that local governments face is not just a balance sheet crisis, but a fiscal crisis. Local governments obtain revenues through a fraction of the value added and corporate taxes collected in their jurisdiction, and all personal income taxes and business taxes. Extra-budgetary revenue has come mainly from land sales. All sources of income are insufficient, however, to cover expenditures, and not high enough to spur implicitly necessary growth.

The lack of sufficient local government revenue led governments to borrow to finance projects through local government financing vehicles, entities set up as corporations that, unlike local governments themselves, can borrow on the market. The 2008-09 fiscal stimulus package operated largely by pressuring local governments to spend on infrastructure, and in order to fund these projects, local government financing vehicles had to borrow big. Local government debt grew so large, that the central government announced that local governments would be able to issue bonds in order to cover the debt. Ten local governments, in Shanghai, Zhejiang, Guangdong, Shenzhen, Jiangsu, Shandong, Beijing, Qingdao, Ningxia and Jiangxi, were permitted to issue bonds in May 2014. The yields of these municipal bonds must be higher than the yield on central government bonds, which continues to pressure local governments to achieve sustained growth, setting up local governments for yet another round of debt-fueled growth.

To conclude, the basic central-local government fiscal relationship must be changed to reduce incentives for local officials to take on bad debt. This has been stated before but cannot be stressed enough. Allowing some over-indebted local governments to set up asset management companies has positive short-term implications, but in the long run, the fiscal shortfall will bring local governments back to a position of excessive debt once again. The solution would be for the central government to allot more local revenue to local governments, require a system of checks and balances to ensure the money is spent wisely, and reduce pressure to generate growth at all costs. Only then can local government debt become qualitatively and quantitatively healthier.

More in the Diplomat.

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