BEIJING – Since the eruption of the global financial crisis in 2008, China has used massive economic stimulus to sustain GDP growth. But unresolved structural problems have meant that the stimulus packages generated significant fiscal and financial risk, while doing little to improve China’s capital stock.
Indeed, while China’s overall capital stock is by no means small, capital-structure and maturity mismatches have led to the accumulation of massive volumes of non-performing assets, undermining China’s economic stability and financial efficiency. In order to create the stability needed to reach the next stage of economic development, China must shift its focus from sustaining high GDP growth toward revitalizing its capital stock.
China’s new leadership seems to recognize this. Premier Li Keqiang has declared that the government will not introduce any additional economic stimulus; instead, the authorities will pursue profound and comprehensive economic reform, even if that means slower GDP growth.
Moreover, Li has called upon the banking sector to reinvigorate idle capital and allocate incremental capital more effectively. And the State Council recently published Guidelines for the Structural Adjustment, Transformation, and Upgrading of the Financially Supported Economy, which outlines ten key measures for revitalizing the capital stock.
This implies major macroeconomic reforms. China’s government is now attempting fiscal decentralization to revitalize the public-finance position, while adopting financial decentralization to maintain currency stability. Indeed, the quest for macroeconomic balance has become the the government’s main economic-policy goal.
Over the last three decades, the gradual decentralization of China’s fiscal-management system enabled it to regulate fiscal transfers to sub-national governments, with the primary aim of clarifying revenue and expenditure at all levels of government. Why, then, did local-government balance sheets swing from surplus to deficit over the same period?
In 1994, China’s economic-reform process reached a turning point with the introduction of a tax-distribution system that reduced the proportion of tax revenue held by local governments from 78% in 1993 to 52% in 2011, while raising the proportion of expenditure from 72% to 85% over the same period. Faced with intense competition to contribute to GDP growth, local governments were compelled to seek other ways to augment fiscal revenue.
As a result, they turned to land transfers and debt financing, exacerbating the problem of soft budget constraints. Cash-strapped local governments began seizing farmland in order to sell it to commercial real-estate developers, while accumulating massive debt through off-balance-sheet loans and short-term interbank funding to finance local-government investment vehicles and real-estate investment. In doing so, they dramatically increased their financial vulnerability.
By the end of 2012, the combined liabilities of 36 of the most indebted local governments totaled roughly ¥3.8 trillion ($620 billion), up nearly 13% from 2010. Furthermore, a large proportion of the credit was invested in the overheated real-estate sector, as well as in infrastructure projects with low rates of return, creating large-scale structural overcapacity that has undermined the efficiency of investment and resource allocation, and contributed to the structural mismatch of fiscal resources.
Now, China’s government must take fiscal decentralization further, giving each local government the authority to collect taxes and control its budget’s scale and structure. Only by adjusting the distribution of public finance can China’s leadership help local governments to decrease their reliance on land-transfer revenues and bank loans.
The next challenge for China’s leadership is to establish better mechanisms for ratification and approval of the overall budget, which comprises the general public budget, the government-fund budget, and the budget for state-owned capital. Currently, while sub-national governments are required to submit their budgets for approval to the people’s congress immediately above them, as well as to the National People’s Congress, the drafts undergo little scrutiny. Ensuring that all budgets are reviewed by people’s congresses at various levels would enhance resource efficiency by reducing fiscal competition between the central and local governments as well as among local governments.
China can further enhance the capacity of existing financial resources to support the real economy through financial decentralization. In recent years, the central government has tightened its control over the banking sector, undermining the financial system’s development, not least by impeding banks’ ability to assess credit risk. By forcing banks to offer lower interest rates to state-owned enterprises, the government drove private firms and households to informal lenders, fueling the emergence of a large and risk-laden shadow-banking sector.
Likewise, the requirement that banks offer very low or even negative real interest rates to private depositors drove them to invest in fixed assets, leading to overcapacity in some sectors, such as real estate. As a result, market-oriented interest-rate reform is now needed to help optimize capital allocation and support the development of China’s financial market, thereby laying the groundwork for future capital-account and exchange-rate liberalization.
But financial decentralization extends beyond interest-rate liberalization. Breaking the central government’s domination of China’s financial resources will fundamentally change the system of implicit guarantees that is currently generating significant financial risk. It will also help to synchronize financial development between urban and rural areas, ultimately eliminating China’s longstanding dual financial structure.
If China’s leaders are genuinely committed to revitalizing the capital stock, they must begin with fiscal and financial decentralization. Such an approach would promote efficiency, stability, innovation, and dynamism at the local level – exactly what China needs to support its progress toward advanced-economy status.