Many years of expansionary fiscal policy have greatly stimulated China’s infrastructure development and economic growth, but resulted in a huge accumulation of government debt. China’s government debt, particularly local government debt, has reached a historical high, causing deep concern among economists, investors and policy-makers worldwide over China’s fiscal sustainability. The Chinese government has recently adopted a precautionary fiscal policy to avoid over-accumulation of government debt. This article analyzes the policy change, and discusses its expected consequences.
Accumulation of Government Debt
Debt issuing is a method for infrastructure financing, which allows the government to acquire extensive funds in a short period of time. Unlike taxes, fees and user charges, debt financing can spread the production cost of infrastructure over successive generations of service users or beneficiaries. In the US, federal, state, and local governments have issued bonds to finance public capital projects, including schools, roads, and water and sewer systems. Since the early 1970s in Japan, bond issuance for public works has become an important financing instrument, especially during periods of economic recession.
China had no government debt before 1978. In the early 1950s, the Chinese government issued domestic bonds and borrowed from the Soviet Union to solve the revenue shortage problem. Soon the relationship between China and Soviet Union turned cold due to ideological differences after Nikita Khrushchev came to power. From 1958 to 1978, China did not issue new debt and in 1965 China paid off all its foreign debt. From 1965 to 1978, China had no international and domestic debt. However, the government did have deficits which were financed by issuing money.
China had moderate government debt from 1978 to 1998. Since the implementation of economic reforms in 1978, the Chinese government has begun to issue bonds. In the 1980s and early 1990s, the size of government debt was small. The debt-to-GDP ratio was 5.4 percent in 1995 and 7 percent in 1997.
China’s government debt increased rapidly since 1998. Immediately after the Asian financial crisis in 1997, China adopted an expansionary fiscal policy, with budget deficits staying at a high level, and government debt increasing rapidly. The budget deficit-to-GDP ratio was 0.7 percent in 1997, 1.1 percent in 1998, 1.9 percent in 1999, 2.5 percent in 2000, 2.3 percent in 2001, 2.6 percent in 2002, 2.2 percent in 2003, 1.3 percent in 2004, 1.2 percent in 2005, and 0.8 percent in 2006. The debt-to-GDP ratio was 9.2 percent in 1998, 11.8 percent in 1999, 13.1 percent in 2000, 14.2 percent in 2001, 16.1 percent in 2002, 16.6 percent in 2003, 16.1 percent in 2004, 17.4 percent in 2005, 16.2 percent in 2006, and 20.2 percent in 2007.1
In the wake of the 2008 global financial crisis, the government again adopted an expansionary fiscal policy, and government debt, particularly local government debt, increased dramatically. China’s government budget deficit accounted for 2.3 percent of gross domestic product in 2009, 1.7 percent in 2010, 1.1 percent in 2011, 1.7 percent in 2012, 1.9 percent in 2013, 2.1 percent in 2014 and 2.3 percent in 2015. Noticeably, the share of government budget deficit in GDP in 2015 was as high as that in 2009, the year when China launched its large stimulus package. China’s central government debt-to-GDP ratio was 17.5 percent in 2009, 16.7 percent in 2010, 15.1 percent in 2011, 14.8 percent in 2012, 14.6 percent in 2013 and 14.9 percent in 2014.
China’s total government debt had already reached 60 percent of GDP in 2014, hovering at the upper limit set by the European Union for its member countries.
Local government debt is higher than central government debt. Local government debt has mainly come from bank borrowing through local government investment companies or financing vehicles. There are various reasons for the increase in local government debt. First, the expansion of local government fiscal responsibility. In 2014, local governments were allocated 54 percent of total government revenue but had to undertake 85 percent of total government expenditure. Second, a large percentage of transfers have been in the form of appropriations for special projects (matching grants), which local governments cannot dispose of freely. Third, local governments can no longer rely on administrative and operations fee collections for revenue, and revenue from land leasing are also inadequate. Fourth, the global financial crisis and the central government’s expansionary policy have sped up local governments’ debt accumulation. Fifth, the high demand for local infrastructure development. It is estimated that the local government debt-to-GDP ratio was 7.9 percent in 2000, 15.2 percent in 2005, 17.7 percent in 2008, 26.1 percent in 2009, 26.1 percent in 2010, 25.8 percent in 2011, 29.8 percent in 2012, 30.4 percent in 2013 and 37.7 percent in 2014.2 Apparently, the size of local government debt has been increasing.
Adding up the central government debt, local government debt, the debt of government-owned Railroad Corporation and government branches, as well as the social security personal account debt, China’s total government debt had already reached 60 percent of GDP in 2014, hovering at the upper limit set by the European Union for its member countries.
Debt, Infrastructure, and Economic Growth
Under the expansionary fiscal policy, many infrastructure projects have been built in China, and the Chinese economy has grown at an extraordinary rate.
Infrastructure development was very fast in the past eighteen years. The growth rate of electricity infrastructure was 7.6 percent from 1978 to 1998, and 10.8 percent from 1998 to 2013. The growth rate of roads was 1.8 percent from 1978 to 1998 and 8.1 percent from 1998 to 2014. Petroleum and gas pipelines grew at 5.1 percent from 1978 to 1998 and 10 percent from 1998 to 2014!
Along with the fast infrastructure development, China’s economy has been growing rapidly. The average GDP growth rate was 9.6 percent from 1998 to 2014, while it was 9.3 percent from 1978 to 1998. The growth rate of GDP was 7.8 percent in 1998, 7.6 percent in 1999, 8.4 percent in 2000, 8.3 percent in 2001, 9.1 percent in 2002, 10 percent in 2003, 10.1 percent in 2004, 11.3 percent in 2005, 12.7 percent in 2006, 14.2 percent in 2007, 9.6 percent in 2008, 9.2 percent in 2009, 10.6 percent in 2010, and 9.5 percent in 2011.
High growth was also accompanied by high government tax revenue growth. Government revenue grew fast only after the 1994 tax reforms, while GDP growth has been high both before and after 1994. From 1978 to 1994, the average annual growth rate of budgetary revenue was only 2.47 percent. From 1994 to 2010, the average annual growth rate of government budgetary revenue was 15.61 percent. The growth rate of government revenue was 17.2 percent in 1998, 19.45 percent in 1999, 18.23 percent in 2000, 23.3 percent in 2001, 16.89 percent in 2002, 14.97 percent in 2003, 18.25 percent in 2004, 18.89 percent in 2005, 21.25 percent in 2006, 27.56 percent in 2007, 9.6 percent in 2008, 9.2 percent in 2009, 10.6 percent in 2010, 9.5 percent in 2011.
The high growth of government revenue helped the infrastructure development and economic growth, as well as the establishment of social welfare programs in rural China, such as the rural cooperative healthcare system and the rural social security program.
Problems with High Government Debt
China’s government debt-to-GDP ratio is currently higher than that of many developing countries, but lower than that of many developed countries. In 2014, the debt-to-GDP ratio was 15 percent in Chile, 42 percent in Mexico, 45 percent in Argentina, 59 percent in Brazil, 28 percent in Indonesia, 53 percent in Malaysia, 51 percent in the Philippines and 46 percent in Thailand. The ratio of government debt to GDP in most of the advanced economies has been increasing. In 2014, the debt-to-GDP ratio was 226 percent in Japan, 179 percent in Greece, 132 percent in Italy, 103 percent in the United States, 88 percent in the United Kingdom and 75 percent in Germany.3
China’s government debt is unevenly spread, with several provinces registering relatively higher debt-to-GDP ratios. The estimated debt-to-GDP ratio as of end June 2013 was 90 percent for Guizhou, 66 percent for Chongqing, 57 percent for Yunnan, 56 percent for Qinghai and 53 percent for Gansu, while it was only 14 percent for Shandong, 18 percent for Guangdong and 20 percent for Zhejiang.4
A major reason for China’s slowing economy is the slowdown of infrastructure development which is caused by the central government’s restriction on bank borrowing by local governments and the slow growth of local government revenues.
High government debt poses a threat to China’s financial system. As mentioned earlier, local governments borrowed a large amount of money from commercial and policy banks for infrastructure development. These local governments are worried that banks will not continue to lend them money to pay their old debts, while the banks are worried if the local governments are able to repay their debt. In addition, foreign investors are worried about the stability of China’s banking system.
High government debt will eventually hinder China’s economic development. As we know, the Chinese government borrowed money for infrastructure construction. The efficient use of the money is crucial. If the funds from borrowing are used effectively, then the borrowing will be beneficial for economic growth, and vice versa. Based on the law of diminishing marginal productivity, too much spending on infrastructure may decrease the productivity of the spending. That is not to mention the bad planning, waste of resources, and corruption that accompany infrastructure development, reducing the effectiveness of government investment. Thus, too much debt may be detrimental to economic growth in the long run. High local government debt has already negatively affected the Chinese economy, and recently the Chinese economy has slowed down. Calculated based on the constant retail price index, GDP grew 10.6 percent in 2010, 9.5 percent in 2011, 7.7 percent in 2012, 7.7 percent in 2013, 7.3 percent in 2014, and 6.9 percent in 2015, compared to an average of 12 percent during the period of 1990-2010.
Premier Li Keqiang announced that the new administration would keep budget deficits and government debt in manageable ranges, and in recent years he reiterated that the government would not adopt aggressive expansionary fiscal policy.
China’s fiscal pressure will be tremendous in the future. The Chinese government accumulated a large amount of debt in a period when the economy was rapidly growing, while some other countries, such as the United States and Japan, accumulated a large amount of government debt when their economies were in trouble. A rapidly aging population in China implies that its social security and health insurance accounts will face increasing debt, and welfare payments will increase. Also, environmental spending is expected to increase substantially in the future. In addition, the slow growth of government revenue may become a serious problem. Thus, China faces the risk of a debt payment crisis in the future.
New Fiscal Policy
The Chinese government has geared towards a new fiscal policy. Debt crises in Greece and other countries have alarmed the world about the risk of high government debt. The Chinese government began to pay attention to the over-accumulation of government debt in 2011 when the National Auditing Administration of China unveiled the Auditing Report on Local Governments’ Debt. The new administration came to office in 2013. Premier Li Keqiang announced that the new administration would keep budget deficits and government debt in manageable ranges, and in recent years he reiterated that the government would not adopt aggressive expansionary fiscal policy. The central government has monitored the local government debt closely, and the National Auditing Administration of China disclosed the information on local governments’ debt in 2013 and 2015.
This year’s overall size of the budget deficit is smaller than in recent years. Including local government fiscal deficits, China’s government budget deficits were very high in the past two decades. In many years, if local fiscal deficits were included, the ratio of government fiscal deficits to GDP was higher than 4 percent, and in 2009 this ratio reached more than 10 percent. In March 2016, the government announced that government budget deficits would be 3 percent of GDP, the highest since 1979. This appears to be inconsistent with Premier Li Keqiang’s promise of no large fiscal stimulation. However, we must realize that this year’s budget deficit is the total budget deficit of the central and local governments. Thus, there is actually a policy change by the Chinese government.
Moreover, the government announced that this year’s budget deficit would come mainly from tax cuts. A tax reform called “ying gai zeng” (i.e., replacing business tax by value-added tax). Business tax is collected from service industries at the basic rate of 5 percent, while value-added tax is collected from manufacturing industries at the basic rate of 17 percent. Starting from May 1, 2016, all industries will adopt the value-added tax. After the service industries adopt the value-added tax, the tax base will decrease, which tends to reduce tax revenue; but the tax rate will also increase, which tends to increase tax revenue. The net effect on tax revenue depends on the magnitude of the change in the tax base and tax rate. An experiment in recent years indicated that the increase in tax rate was not enough to offset the decrease in the tax base. Thus, this tax reform has resulted in a decrease in tax revenue. The decrease in taxes will help business investment and economic growth.
Eliminating the local government financing platforms and allowing local governments to issue bonds. On January 11, 2016, the Ministry of Finance announced that China will eliminate the local government financing platforms and commercialize them. Under the 1995 budget law, China's local governments were banned from issuing bonds directly or from running budget deficits. However, under the 2014 budget law, local governments have the right to issue bonds, the quantity of which must be approved by the central government. To reduce financial risks, the Chinese government has adopted the “bonds-for-loans” reform, i.e. issuing bonds and using the revenue to repay bank loans. For many years, local governments have utilized local government financing vehicles to borrow money from commercial and policy banks. Bank loans to local governments may become non-performing loans and could imperil the financial sector. Allowing local governments to issue bonds will make the fiscal system more transparent, and this will help in putting local government debt under control.
Many years of expansionary fiscal policies have resulted in a large amount of government debt in China. Including government contingent debt at the local level, China’s government debt-to-GDP ratio has already reached 60 percent, the debt ceiling set by the European Union for its members. Massive government borrowing has speeded up China’s infrastructure construction and economic growth. However, a high level of government debt constitutes a threat to the commercial banking system, undermines fiscal sustainability, and hinders China’s long-run economic growth.
The new Chinese administration is geared towards adopting a precautionary fiscal policy. Including local government implicit fiscal deficits, China’s government fiscal deficits were very high in the past 20 years. The central government has realized the risk of the over-accumulation of government debt, and has put strict restrictions on local governments’ borrowing and closely monitored local government debt. Including local government borrowing, the ratio of China’s fiscal deficit to GDP went over 4 percent in many years. Although the ratio of the explicit government budget deficit to GDP reached 3 percent this year, the local government implicit fiscal deficit is prohibited.
Some well-known scholars in China are unhappy with this year’s government budget, suggesting that the government should have a higher level of budget deficits and have a more aggressive simulative fiscal policy. More fiscal stimulation can increase output growth in the short run, but cannot sustain economic growth in the long run. The current growth rate for China is not too low, and the Chinese government should be patient and give the market a chance to adjust itself.
With a high savings rate and a large accumulation of human capital over the years, China’s economic growth potential is enormous. Staying with a prudent fiscal policy and relying more on private investment, the Chinese fiscal system will be sustainable and the economy will grow at a reasonably high rate in the foreseeable future.
1. Unless specified otherwise, data used in this article are from: National Bureau of Statistics (2015). China Statistical Yearbook. Beijing: China Statistics Press.
2. Calculated based on: National Auditing Administration of China (2011). Auditing report on local governments’ debt; and The State Council of China (2015). Proposal on local government debt in 2015. Retrieved from http://www.chinanews.com/gn/2015/08-29/7496482.shtml
3. See BVD--EIU country data. Retrieved from https://eiu.bvdep.com/version-201633/cgi/template.dll?product=101&user=ipaddress&dummy_forcingloginisapi=1
4. Calculated based on: National Auditing Administration of China (2013). Auditing report on local governments’ debt.