While President Xi is resolutely holding onto his signature dynamic zero Covid policy, other party leaders are pulling as many policy strings as they can to resuscitate the faltering Chinese economy. They are lowering the five-year loan prime rate, renewing support for platform companies, easing overseas listing rules, and reassuring the world that China’s reform and opening up isn’t over but will continue to expand. But alongside China’s Sisyphean fight against Covid lies its real Achilles heel: mounting local government debt (LGD).
It is little known that for many years, Beijing has been purposely quiet about the risks of LGD, even though many China analysts and observers have been sounding the alarm for a long time. Only beginning in 2017 did the party’s Central Leading Group on Finance and Economic Affairs and the state media begin to label LGD as a threat to the economy, sounding alarm bells by calling it a “gray rhino.” Why the long reticence?
In a recent article published in the China Journal, we explored this puzzle with publicly available data, government documents, and personal memoirs and found that the LGD problem was, in a way, by design. For a long time, the center chose to keep its eyes closed to the problem, as it was the outcome of a “grand bargain” between the center and localities in the mid-1990s. “[Total revenue and total spending are your [i.e., local governments’] own secret. I only care about how much the center is getting,” said Zhu Rongji, China’s then vice premier and the architect of many key reforms.
To compensate for local losses after a set of centralising economic reforms in the 1990s — especially the 1994 tax reform, which sharply reduced local shares of budgetary revenue — Beijing gave localities brand new tools and unprecedented fiscal autonomy to promote economic development. The institutional seeds of LGD were sown. Deeply intertwined, these seeds grew together and fed into each other. Two of them are particularly worth highlighting, as they continue to matter tremendously in Chinese political economy: the local state banks and local government financing vehicles.
To solicit local support for fiscal recentralisation in 1994, Beijing used bank charters as a bargaining chip. Since then, the number of local financial institutions in China has proliferated exponentially, reaching well over 2,000. These smaller institutions are either directly owned or controlled by local governments, thus their “statist” nature. To survive and thrive in a market already dominated by the several gargantuan central state-owned banks, these small players innovated, providing a tremendous impetus to the rise of shadow banking in China, another source of systematic economic risk.
Whether the local state banks prosper or perish will be a harbinger for the Chinese economy as a whole. At the epicenter of the recent well-known Evergrande crisis was a local state bank that used to provide the real estate company with substantial financial support through related lending. With the Chinese economy presently hobbled, some local state banks have begun to crumble. The recent deposit freeze at three village banks in Henan is one such bad sign. Systematic central bailout is increasingly foreseeable down the road.
What does the rise of the local state banks have to do with local government debt? After all, Chinese law prohibits local governments from borrowing from any bank. Herein lies the genius of local governments: they created middlemen, local government financing vehicles , to borrow from banks. And Beijing acquiesced. These corporations played an especially important role during the 2008 global financial crisis, as localities engaged in a borrowing binge to contribute to Beijing’s stimulus package: at least half of the lending was from the local state banks, as it was much easier and faster to receive funds from them than from the large state-owned ones.
However, at approximately the same time that the global financial crisis stimulus loans were coming due, and the localities were allowed to issue municipal corporate bonds, Beijing began to tighten fiscal discipline, resorting to more direct measures to tamp down and regulate local debt. Departing from its earlier grand bargain with the localities, the center began to aggressively limit local debt and mandate more transparency in local government fiscal actions.
Beijing also tried to reduce debt by disciplining local government officials. In recent years, the center incorporated a “debt” component into cadre evaluation criteria. Local officials would be evaluated based on how well they solved debt problems, including those left by their predecessors, and were to be punished for blindly raising debt. While new debt might have decreased temporarily, it soon came back, particularly once Covid hit.
As the zero Covid policy brings China’s economic center to a standstill, Beijing is again demanding that localities increase spending to stimulate the economy, while keeping the astronomically stringent Covid policy intact across the country. Yet, Beijing’s “spend more money” directive to local governments cuts against its own recent commitment to rein in LGD. It’s only a matter of time before the debt issue resurges forcefully as the country juggles between growth promotion and Covid elimination.
But here is the punchline: local government debt in China is not a local problem. It’s an institutional malaise. The Chinese state faces a dilemma that, in essence, is a “dual-commitment problem.” Growth without mounting debt requires the central state to simultaneously commit to respecting its local agents’ access to and control over the fiscal fruits of local development, while exercising credible fiscal discipline over precisely the same set of local agents that the center seeks to incentivize. Can this dual-commitment problem ever be solved under China’s current political structure?