Can China spend its way out of economic crisis?
Falling tax revenue and high local debt cast doubt on how much budgetary firepower Beijing really has
This month, China’s new finance minister Lan Fo’an told markets what they had been waiting to hear — Beijing would boost budget spending to support a delicate post-pandemic recovery in the world’s second-largest economy.
China is to deploy an arsenal of local and central government bonds, including a new Rmb1tn treasury facility — which will push Beijing’s budget deficit up to a two-decade high of 3.8 per cent this year, Lan said, to “maintain fiscal spending intensity at an appropriate level”.
But while the message was welcomed by investors, many analysts question just how much budgetary firepower Beijing really has to boost flagging confidence in the economy and drive stronger momentum for growth.
With economic growth slowing and Beijing’s former investment-led development model losing steam, tax revenue is under pressure, analysts say. Beijing is reluctant to borrow more, given that it has huge pools of bad debt to resolve at the local government level.
“This is the longer-running story — that fiscal policy has been constrained for the last three to four years,” said Logan Wright, director of China markets research at Rhodium Group. “[And] it’s becoming more and more constrained in terms of what it can actually do.”
This year, as the economy struggled to rebound from a downturn wrought by zero-Covid controls in 2022 and a property slowdown, the government responded with incremental easing measures.
Beijing is reluctant to ramp up leverage as it did after the financial crisis in 2008, when it unleashed a Rmb4tn stimulus then worth 13 per cent of gross domestic product.
This time around, the central government has not leveraged what, on the face of it, is a relatively clean balance sheet, analysts say. Compared with local governments, which have debt worth about 76 per cent of GDP, the central government had only about 21.3 per cent last year, according to Wright.
“We would argue Beijing has considerable fiscal resources at its disposal,” said Fred Neumann, chief Asia economist at HSBC. He said Beijing had room to add more debt worth about 20-30 percentage points of GDP, which would go a long way to solving local government debt problems.
IMF analysts also said in a paper released in August that China’s net financial position, taking into account its assets such as equity holdings, was among the top 15 in the world, at 7.25 per cent of GDP, though this has been steadily declining and the valuation of the assets were subject to uncertainty because of factors including liquidity.
Most analysts believe, however, that the central government’s real debt obligations are much bigger than the numbers suggest. Beijing acts as the ultimate backstop for the country’s total government debt, estimated by Rhodium’s Wright at 142 per cent of GDP last year, including that held by the central government, policy banks, local governments and local government financing vehicles (LGFV) — off balance sheet entities that raise their own funds.
“In China, the boundaries are a bit blurred,” said Hui Shan, economist at Goldman Sachs, on how to calculate the government’s total debt liabilities. “At what point does an LGFV’s obligations end before they become the responsibility of the local government — it’s hard to draw that line.”
Resolving local government debt problems has become one of the most urgent issues for Beijing. Upgrading China’s economic growth forecast for this year to 5.4 per cent from 5 per cent, the IMF said that Beijing still needed to “implement co-ordinated fiscal framework reforms”.
Since September, Beijing has been asking state banks to lower interest charges and extend the tenure of local government loans, Gavekal Dragonomics wrote. Beijing has also been allowing provincial governments to issue bonds to repay LGFV debts.
By early November, at least 27 provinces and one municipality had issued Rmb1.2tn of the bonds, which use quotas for local government bond sales that were allocated in previous years but not fully utilised.
By bailing out local governments with another round of bond swaps — the last one was in 2015-18 — the central government was prioritising “preventing risk”, Gavekal said. That meant stopping damaging defaults in the bond market that could have a huge ripple effect.
This comes at the expense of promoting a sense of moral hazard among local government borrowers. But there are signs Beijing is becoming less demanding on local governments over growth targets, which should lessen the need to overborrow in the future.
“The message goes out to local government officials that ‘we’re not putting quite as much pressure on you as in the past to achieve exceptionally high rates of growth, so you don’t need the LGFVs as much as in the past’,” said Chris Beddor, deputy director of China research at Gavekal.
But the central problem of inadequate government revenue generation will still remain, analysts say. Under reforms in 1994, the central government controls tax revenue while local governments are responsible for more services. Short of cash to meet all their obligations, many local governments have typically overborrowed.
“The fiscal structure is really why we got into this mess. So there needs to be ultimately a change in political incentives, maybe a change in the fiscal structure in order to get us out of it,” said Beddor.
But the other critical problem was that as China’s old debt-fuelled investment model switched towards a more consumption-based one, revenues from land sales and value-added taxes had fallen, particularly as the property market had imploded in recent years.
Aggregate tax collection to GDP is down from 18.5 per cent in 2014 to 13.8 per cent last year, Rhodium’s Wright said.
The Chinese Communist party could increasingly face stark choices about how to balance social and development needs with some of President Xi Jinping’s strategic objectives, such as developing high-tech industries or overseas infrastructure projects.
“There’s a bigger problem of how do you maintain fiscal resources in the system,” Wright said. “And the point is, China faces very meaningful trade-offs between all of these adjustments.”
China could increase its fiscal deficit further but this was already high at an aggregate 7 per cent of GDP, Wright said. “Yes, you can ramp that up to 8-9 per cent, but then there’s almost nowhere to go,” he said. “It’s really hard to continue to expand.”