Little has changed three years after policymakers and China watchers were shocked by the extent of local government borrowing revealed by China’s first national audit. On December 30, China’s National Audit Office released an update showing that local government borrowing has not only grown but the structure of borrowing if anything has gotten worse. The results of the audit reiterate that regulatory efforts to control the rise of local government borrowing have been ineffective, and more comprehensive fiscal reforms are the solution to control growing risks in local government borrowing.
Government regulators have failed at controlling the level of local government debt. Subnational borrowing has continued to outpace GDP since regulators took actions to contain local government borrowing following the results of the first audit in 2011. In the first half of 2013, local government debt outstanding has reached 33.2 percent up from 26.7 percent in 2010.
The failure to stem the increase in the level of local borrowing is not yet a major concern for China. China’s central and local government liabilities totaled only 54 percent of GDP at the end of 2012, a 20 percent increase from 2010. This level is in line with most major developing countries and much lower than major developed countries, including the United States, Germany, and Japan. China has better growth prospects and more plentiful domestic savings than these countries, ensuring the central government in theory has the fiscal capacity to cover subnational governments.
More worrisome is the fact that the risks to the financial system associated with the current structure of local borrowing have worsened since 2010. Today even more of China’s local government debt consists of short term contingent liabilities. The share of subnational debt maturing in less than three years has risen with 59 percent of local government debt set to mature by the middle of 2016. In contrast, the first audit showed that at the end of 2010, only 53 percent of debt was to mature by the end of 2013. Shorter term maturities are a problem because most of the debt still consists of projects with longer term payoffs such as infrastructure. This mismatch makes it more likely that the borrower will need to rollover their debt.
Contingent liabilities also create ambiguity as to what extent the local government will cover losses in the event of default. The audit reveals local governments continue to rely on local government financing vehicles (融资平台公司) as the dominant issuer of local government debt. Some of the borrowings by these thinly capitalized special purpose vehicles are not directly covered by local governments. Today, close to 40 percent of outstanding liabilities are now in the form of contingent liabilities rather than borrowing directly covered by local governments (政府负有偿还责任的债务), 2 percent higher than three years ago.
Worse more borrowing is coming from non-bank sources. The share of bank borrowing fell from 79 percent in 2010 to 57 percent in the first half of 2013. Some of this change is a result of an increase in direct bond issuance by local governments. This is a positive sign. However, indirect borrowing from non-bank financial institutions via platform companies brings additional risks. It is more difficult for regulators to contain potential defaults of local government financing vehicles in non-banking funding channels. Lending by non-bank financial institutions such as trust companies also tends to be more costly, more opaque, and of shorter maturity.
The most important takeaway is the growing imperative for the central government to execute on the reforms to local finances outlined in the third plenum. Tax and budget reforms are needed to reduce the financial burden of subnational governments, in particular heavily leveraged municipal and county governments, reducing any uncertainty about their ability to cover existing debt levels. The proposed expansion of a program to allow direct subnational bonds issuance will also help reduce contingent liabilities and maturity mismatches in local borrowing.
This month, the Central Economic Work Conference outlined controlling local government risks as one of the work items for 2014. With the new audit now in hand, policymakers should have the tailwind necessary to execute on significant fiscal reforms this year and contain the risks highlighted in the second national audit.