Four Issues to Understand China’s Fiscal Health
Author: XU Qiyuan SHENG Zhongming
Recently，China’s local government debt has received widespread attention，and the discussion on local government debt tends to lead to the assessment of the government’s fiscal condition. Over the past years，the government’s capacity to increase revenue has been curbed due to tax-and-fee-cut policy，the economic downturn，and the slide in the real estate market. In this context，there are increasing concerns regarding fiscal deficits and the risks associated with debt.
Is there any solvency risk of local government debt? Is it necessary for China to raise debt to promote infrastructure development? What were the problems with the previous build-up of local government debt? What are the implications of the radical change in the land market? These concerns should not be evaluated in isolation but must be systematically examined and tackled in accordance with China's distinct circumstances and current level of progress.
The Risks of Local Government Debt Lie in Liquidity Instead of Solvency
The public concern about the risk of government debt is not hard to understand because Chinese people only learned about debt first hand after the commodification of housing just over 20 years ago. Moreover，the Chinese government accumulated debt only a decade earlier than ordinary citizens.
In 1981，after 23 years of "no internal or external debt" (1958-1980)，China resumed the issuance of national bonds. Initially，"everyone thought China was forced to issue bonds in 1981，and there would be no second time" (GAO Jian，2009). Surprisingly，despite initial efforts to reduce it，China's government debt has continued to grow steadily over time. National bonds have been consistently issued，and local government financing vehicles have taken on many government functions in construction which issued significant amounts of debt. This trend began with the "Wuhu model" in 1998，which created implicit government debt. In 2014，provincial governments were granted greater autonomy to issue local government bonds.
By the end of 2022，the Chinese government had an explicit accumulative debt of 60 trillion yuan (25 trillion central government debt and 35 trillion local government debt). Local government financing vehicles (LGFV)，closely associated with the government，hold an interest-bearing debt balance of approximately 60 trillion yuan. According to the IMF’s estimated ratio (two-thirds of LGFVs as implicit government debt)，40 trillion yuan can be considered implicit government debt.
Overall，China’s general government debt has grown from zero to 100 trillion yuan within just 40 years，which naturally caused concerns about debt risk. The risk of local government debt received the greatest attention because 75 trillion yuan of government debt is local debt.
From an asset-liability standpoint，local government debt does not present a risk to solvency. The primary issue is liquidity risk. China is a nation with a socialist system that features public ownership as its fundamental foundation. At all levels of local government，although they have debts，they also possess an abundance of state-owned assets.
According to the Comprehensive Report on the Management of State-owned Assets in 2021 by the State Council，as of the end of 2021，local non-financial state-owned enterprises had total assets of 206 trillion yuan and total debt of 130 trillion yuan (including local government financing vehicle debt). The debt-to-asset ratio was 62.8%，indicating a healthy structure. If non-financial central state-owned enterprises and national administrative and public state-owned assets were taken into consideration，the total non-financial state-owned assets in the country would exceed 360 trillion yuan.
There are five main models for addressing local debt risk using state-owned assets.
First，a direct model of “renting out and selling the assets”. Second，the "debt-for-equity swap" model involves the incorporation of asset management companies (AMCs) as shareholders. After solving the debt issue，the agency can exit through equity repurchase from indebted state-owned companies and indebted shareholders or equity sale to a third party. Third，a model of state-owned debtors "repaying debt by selling equity," which primarily takes place within the state-owned sector. For example，Guizhou Expressway Group divested its shares to Moutai Group. Forth，a refinancing or debt extension model by negotiating with state-owned financial institutions for debt repayment. Fifth，a model of asset securitization，mainly including asset-backed securities (ABS) and real estate investment trusts (REITs).
Among these models，the initial two raised concerns regarding the possible loss of state-owned assets. Selling shares to repay debts and renegotiating with financial institutions to extend debt repayment can also trigger moral hazards and financial risks. Moreover，as ABS are essentially bonds，local state-owned enterprises are restricted from issuing ABS.
Regarding REITs，this recently introduced financing model for infrastructure，which raised high expectations，is also encountering challenges (WU Tao et al.，2021). First，companies usually do not fully own the underlying assets in China’s infrastructure projects. The original equity holders are short of effective underlying assets to issue REITs. Second，most of the infrastructure projects cannot meet the liquidity requirement; third，there is a problem of double taxation.
Due to the concerns and limitations mentioned，local governments face obstacles in effectively utilizing their substantial state-owned assets to mitigate debt risks. Therefore，the risks of local government debt mainly lie in the lack of liquidity of state-owned assets.
To address these issues，we should improve local infrastructure financing models based on the reform of state-owned enterprises (SOEs). To address the risks associated with hidden debt，it is recommended that the reform of SOEs should involve the separation of public welfare projects from LGFVs and the promotion of market-oriented reforms. Local governments can employ a range of tools to resolve debts arising from these projects. Additionally，LGFVs should be repositioned as regular SOEs and participate in market competition on an equal footing with other market players.
Building on deepening state-owned enterprise reform，we should explore new financing models for local infrastructure investment. Public welfare projects that lack cash flow could receive funding directly from government credit. Meanwhile，projects with certain cash flows can obtain funds through asset securitization，such as REITs. This requires the provision of high-quality underlying assets for REITs issuance and adjusting tax policy to address issues of double taxation and tax burden on REITs issuance.
China’s Investment Efficiency Continues to be Comparatively High
Most of the local government debt comes from the financing demands of infrastructure investment. Some argue that China’s investment efficiency has shown signs of decline，and there is a possibility that the country’s infrastructure construction has reached saturation point. As a result，there is a debate about the need and necessity to continue strengthening infrastructure investment to boost economic growth.
However，there remains considerable potential for further infrastructure investment in China. According to Statista’s statistics，as of 2021，the Chinese mainland had 248 civil airports in traditional transportation infrastructure，while in 2020，the US had 5,217 public airports (plus 14,702 private airports). Although China has made great progress in high-speed railway construction in recent years，data from the International Statistical Yearbook (2021) shows that in 2019，China's total railway mileage was 68,000 kilometers. In contrast，the United States railway mileage was as high as 150,000 kilometers. In 2019，the road network of China extended up to 5.01 million kilometers，whereas that of the US was 6.64 million kilometers during the same period. In other words，although China has more than four times the population of the US and a comparable land area，the mileage of China's roads，railways，and the number of airports is only 75%，less than 50%，and less than 10% of those in the United States，respectively.
There is still room for improvement in municipal infrastructure construction. Parking shortages and urban waterlogging are common issues in many cities，requiring the construction of additional parking facilities，improvements in road planning，and the installation of underground drainage systems to alleviate these problems. Furthermore，there is a need for development in areas such as digital infrastructure and renewable energy sectors，both of which play a crucial role in facilitating innovation and progress.
In general，China's capital stock per capita is significantly lower than that of the US，and there is ample room for improving investment efficiency. In particular，if the spatial allocation of infrastructure investment is optimized，the efficiency of infrastructure investment can be further enhanced. Scholars such as Liu Shangxi and Lu Ming have proposed adjusting the direction of infrastructure investment based on population mobility. It is suggested to strengthen infrastructure investment in urban and urban clusters with population inflow and to be more cautious in incremental investment in regions with population o