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China’s Never-Ending Stimulus

by | June 9th, 2013 | 10:18 am

During the press conference at the conclusion of the IMF’s Article IV Consultation with China, Deputy Managing Director David Lipton shed a bit of light on China’s debt situation. In the context of emphasizing the need for overall fiscal reform, Lipton revealed that government debt had now reached 50 percent of GDP and the country was running an “augmented” fiscal deficit of 10 percent of GDP.

What is an augmented fiscal deficit? We were a bit confused as well until the IMF released a followup statement on the topic. The new augmented deficit approach combines both the traditional fiscal deficit as well as the borrowing activity of local government financing vehicles (LGFV).

LGFV were at the vanguard of China’s efforts to stimulate its economy during the global financial crisis. These platform companies borrowed heavily from banks during the stimulus, financing a rapid build out of infrastructure that helped sustain economic growth despite the ongoing global turmoil. Many of these infrastructure projects make sense and will generate long-term economic gains. The funding structure, however, is rotten. Local governments borrowed money via bank loans with relatively short maturities and with no transparency. Many of these newly built projects have a severe maturity mismatch, generating positive gains over the long-run but insufficient cash flow to service their debt.

The size of the problem was revealed by the National Audit Office in 2011 when it announced that local governments had run up 10.7 trillion renminbi in debt (26.5 percent of GDP). Since then, new data on local government borrowing has only come out in dribbles. Shang Fulin, Chairman of the China Banking Regulatory Commission, stated late last year that LGFV’s bank debt was equal to 9.3 trillion, showing almost no change relative to the 2010 number. This is in line with the official policy to hold bank loans to local governments to no net growth going forward.

Cut off from new bank loans, local governments turned to other sources of financing. In recent years borrowings from trust companies and issuances of corporate bonds began to dominate the flow of new financing for local governments.

With the creation of the augmented fiscal deficit metric, the IMF has tried to capture the true extent of local government borrowing. The augmented deficit includes not only banks, bonds, and trusts, but also land revenues net of resettlement costs. The argument for including land sales is that they amount to a type of “one-off” privatization of state assets.

The 10 percent augmented fiscal deficit reveals an ongoing counter-cyclical stimulus in China far greater than the small budget deficit run by the central government (1.6 percent of GDP). To put the number in perspective, deficit spending in the United States during the crisis period peaked at just below 10 percent of GDP (2009) and has declined rapidly in subsequent years.

Five years after the crisis, China is still running a large fiscal deficit that is propping up growth. The central government is cognizant of the risks of this strategy and has tried to control the scale and scope of local government borrowing. However, many of its efforts to crack down have only pushed local governments into less transparent financing channels, such as borrowing from trust companies.

The final extent of the government liabilities may be somewhat less given that some of these projects will generate positive cash flows. Regardless, China faces a conundrum of rapidly growing debt at a time of relatively weak economic growth. Attempts to slow debt accumulation by increasing restrictions on local government borrowing will further slow the economy at an unwelcome time. All of this points to the urgent necessity for fiscal reform that results in more sustainable financing model for local governments.