New sources needed and learning from overseas experience advised so local governments can meet obligations

Local public debt is a hotly debated issue in China. People are seriously concerned about the accumulated local public debt, which had risen to 10.72 trillion yuan ($1.58 trillion) at the end of 2010, the equivalent to 26.9 percent of China's GDP that year. Meanwhile, economists and government officials, particularly central government officials, are still struggling to find ways to digest this enormous debt and reduce the severity of its effects on China's economy.

There are two reasons for the sharp rise in local government debt:

First, the mismatch between the obligations and available resources of local governments is the root cause of the debt. Under the current tax-distribution system, which was established in 1994 as the result of the last great reform in China's tax system, the central government claims the revenue from the most lucrative taxes, leaving the local governments with severely restricted financial resources that are unable to meet their growing obligations, especially as the central government has put increasing emphasis on people's livelihoods. Therefore, local governments have had no other option but to finance themselves and their investments through debt.

The second reason is the expansionary financial policies during 2009 and 2010 to boost the economy during the onset of the global recession. In this context, local governments were explicitly and implicitly encouraged to get loans from the banks, particularly the State-owned ones. No wonder that the growth of the balance of local public debt during these two years accounted for almost 50 percent of the balance accumulated since 1997.

Even though local government debt amounted to 26.9 percent of GDP in 2010, it is still well below the internationally accepted alarm level; however, three factors have worsened the situation.

First, issuing local bonds is restricted by the Budget Law and the State Council; however, most local governments raise their debt through financial intermediaries, resulting in an underground "budget" that is unsupervised and without the approval of the local people's congress. This has opened the door to corruption and wastage when allocating public money.

The second factor is the mismatch between the benefit period and the maturity of local public debt. Most local public debt has been invested in infrastructure construction, such as low-income housing and roads, from which local governments only benefit in the long run. Notwithstanding this delayed benefit, most of the debt will mature soon. This mismatch will exacerbate local governments' financial shortages and lead to non-performing loans increasing in the banking system.

Last but not the least, most local governments use land transfer revenues as the mortgage for their debt. Given that local governments collect relatively low revenue from tax, land transfer revenues have become ever more important to local governments as real estate prices have soared, and it is common for them to use this revenue as mortgage. However, with the central government's firm determination to curtail housing prices, the prospects for this revenue are diminishing.

To solve this problem effectively, we have to find appropriate solutions.

First, the central government should delegate the authority of issuing local public debt to local governments and hold them responsible for repayment, make the process transparent and put it under the supervision of the people's congresses and media. This measure would make more financial resources available to local governments. However, the governments should also pay attention to risks and keep them in check.

The second measure is for the local governments to ask for loan extensions. This measure would help to mitigate the mismatch between the benefit period and the maturing of local public debt. However, this measure is based on the assumption that the investments are of good quality and the returns are able to cover both the principal and the interest. If the returns are not so good, this could lead to a sharp rise in non-performing bank loans.

The third solution is transferring more revenue from the central government to local governments. Even though this solution would meet resistance from central government officials; given the rapidly rising revenue of the central government and the obligations of local governments, the central government should transfer more financial resources to local governments so they can deal with their financial pressure and repay their debts.

The fourth measure is to permit and invite more non-government capital to invest in public services and construction. This measure would help mobilize social resources and enable the resources to be invested in a more efficient way, as a number of government-related programs offer high returns. Further, this would alleviate the financial pressure on local governments and provide more resources for developing the local economy. Moreover, local governments and private enterprises can find ways to establish public-private partnerships to complement each other's advantages and achieve more desirable results.

And finally, local governments should be encouraged to find other sources of revenue to relieve the high dependence on land transfer revenues. In the developed countries, there is a greater range of items that are taxed to achieve social benefits. For example, so-called fat taxes that aim to discourage unhealthy diets and offset the economic costs of obesity. Another example is the carbon taxes and auctions of emission permits, which help reduce pollution. China can learn from these examples and introduce more unconventional revenue streams to help finance public services and investment.

The author is a MPA candidate with Lee Kuan Yew School of Public Policy, National University of Singapore.

(China Daily 03/30/2012 page9)