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Fiscal Policy Should Provide Legitimate Channels for Local Gov. Financing

        2018-11-30

Fiscal Policy Should Provide Legitimate Channels for Local Government Financing

 

Zhang Bin, CF40 Senior Fellow

 

The No.23 Document issued by China’s Ministry of Finance has “blocked the back door” for local governments’ illegal debt financing. The Notice not only curbed the over-expansion of local governments and many of their improper behaviors, but also lowered systemic risks for the economy, marking a vital step towards modern economic governance. Meanwhile, we should also see that the current budget allocated to infrastructure is far below the amount needed. Fiscal policies should proactively seek to “open the front door”, i.e. open legitimate channels for financing for b. Otherwise, either the economy suffers unnecessary heavy loss, or the local governments will be forced to again resort to back door solutions, making all previous efforts a waste.

 

The government should acknowledge historical debts arising out of public or quasi-public infrastructure projects and pay for newly-added ones. As for non-public projects, they should be best dealt with through market measures. According to our estimation, acknowledging historical debts will raise the rate of explicit government debt to above 65%, while paying for newly-added public and quasi-public projects will bring a 3-6% rise in government deficit ratio and an 80-110% raise in government debt ratio for the next ten years. The above measures are not aiming at increasing government expenditure and debts. Rather, the goal is to make fiscal debts and deficits explicit and standardized, and thereby facilitate scientific management, maintain macroeconomic stability, reduce economic risks and lessen real fiscal burden in the future.

 

Huge funding gap in public and quasi-public infrastructure

Strict implementation of the No. 23 Document will open a huge gap in public and quasi-public infrastructure investment. Between 2013-2017, China invested around 66 trillion RMB in infrastructure, 90% of which came from the governments and SOEs, 10% from the private sector. Infrastructure investment falls into three main categories: (1) production and supply of electricity, thermal energy, fuel gas and water; (2) transportation, storage and post industries; and (3) water conservancy, environment and public facilities management. Considering the different operational features and investment returns of the projects, we assume that 30% of type (2) projects and 70% of type (3) projects cannot generate enough cash flow to secure funding from the market. Based on this reckoning, infrastructure investments totaling 27.6 trillion cannot get funding from the market, accounting for 42% of the total investments. Budgetary spending on infrastructure was 9.4 trillion for 2013-2017, accounting for 14% of the total investments. In the past, a large proportion of funding for public and quasi-public infrastructure projects came from local government debt financing, which is halted by the No. 23 Document. With the back door shut, a huge funding gap is rising to the surface.

 

The sudden slump in infrastructure investment this year points to the first signs of the problem. Infrastructure investment could continue to face heavy downward pressure in the future. During 2013-2017, the year-on-year growth rate of national infrastructure investment has declined from its peak of 21% to 13% in 2017, with a yearly drop of 2%. By the end of the 3rd quarter of 2018, the growth rate of infrastructure investment (excluding electricity projects) has tumbled to 3.3%. One main cause for the steep downturn of infrastructure investment is the shortage of funding sources. Some local governments’ enthusiasm for infrastructure investment through debt financing is much dampened by the regulation of No. 23 Document. Although the accelerated issuance of special bonds in the second half of 2018 to some extent has alleviated the funding tension, it remains far insufficient to fill the gap. The special bonds are of limited scale and must be supported by cash flow returns. The latter is a requirement most public and quasi-public projects cannot meet.

 

If the No. 23 Document is to be strictly implemented without additional increase of fiscal deficits to support public and quasi-public infrastructure investment, economic growth will experience a sharp slowdown. According to our projection using a VAR model, the growth rate of real GDP will go down from 6.2% in 2018 to 3.4% in 2027, whereas without the decline in infrastructure investment, the rate in 2027 will be 5%. The lack of infrastructure investment will lead to a loss of real GDP growth by over 20% in the next ten years.

 

Since urbanization in China is still underway, infrastructure investment is still in high demand in more developed regions with population inflows. Based on the experiences of Japan, South Korea and Chinese Taiwan, the ratio of infrastructure investment to GDP keeps increasing until urbanization rate reaches 70% and decline significantly after urbanization rate reaches 75%. As for China, in the past decade, the growth rate of infrastructure investment had consistently outpaced that of nominal GDP, and the ratio of infrastructure investment to GDP has remained high. Therefore, it is necessary to make downward adjustment. However, considering China’s relatively low urbanization rate and the large scale of cross-region population flows, better developed regions with population inflows still have high demand and potential for infrastructure investment. From a fiscal perspective, cities with more population inflows and faster economic growth have lower government deficits, thus are more capable of financing infrastructure construction. From a functional perspective, infrastructure construction in these cities can serve more people and better boost economic growth.

 

Scenario analysis on deficit and debt ratio changes for the next 10 years

Two key steps are needed to set a clear boundary between government and market, and achieve scientific management of future government debts.

 

First, incorporate historical debts arising out of public or quasi-public infrastructure projects into government debts, and address debts resulting from non-public infrastructure projects with market-based solutions. Based on our calculation, there are around RMB 24 trillion worth of debts to be included into government debts, and the inclusion will raise government debt/GDP ratio from 37% to 67%. The goal is to turn government debt explicit, increasing government debt while decreasing corporate debt, without affecting the national total debt ratio. Because the government usually pays lower cost for financing, this move will also reduce the real debt cost for local governments. Some government officials and scholars have concerns over the moral hazard of the inclusion, which they believe might encourage local governments to raise more debts. They are in fact concerned about whether the No.23 Document will be effectively implemented. We think that there is no point getting entangled in this issue since the central government has clearly made up its mind to shut the back door to illegal local government debt financing.

 

Second, ensure reasonable infrastructure spending in future budgetary decisions, and seek to minimize real government debt burden while sustaining necessary investment levels for infrastructure construction. Below we have estimated changes of deficit ratio, debt ratio, and relevant macroeconomic parameters in future 10 years, in two possible scenarios:

 

In Scenario 1, we assume that local governments include debts formed through public and quasi-public infrastructure projects into their account, strictly implement the No. 23 Document, keep a yearly deficit ratio of no higher than 3%, and make no additional expenditure on public and quasi-public infrastructure construction. In such scenario, government debt ratio will rise from 67.4% (after the consolidation of statements) in 2017 to 76.8% in 2027. Under this scenario, local governments will stop off-budget financing, and the level of infrastructure investment will drop dramatically, leading to a sharp decline in GDP growth. Within the constraint of a maximum deficit ratio of 3%, the fast drop of GDP growth rate will be one of the contributors to continuously rising debt ratio.

 

In Scenario 2, we assume that local governments include debts formed through public and quasi-public infrastructure projects into their account, strictly follow the No. 23 Document, while allocating budget expenditure to infrastructure so that infrastructure investment grows simultaneously with nominal GDP. In this scenario, budgetary deficit ratio will stay at a high level of around 9%, with government debt ratio rising from 67.4% (after the consolidation of statements) in 2017 to 111.3% in 2027.

 

GDP growth rate will differ significantly in the two scenarios, with that of the second scenario 25% higher than that of the first scenario on average in the future 10 years. Assume that the GDP of 2017 is 100, the GDP of 2027 will be 180 and 216 in Scenario 1 and 2 respectively.

 

Table 1 Dynamic trajectory and decomposed contribution

of debt ratio and deficit ratio 2016-2027 (Scenario 1)

 

Actual value       Estimated value

Year

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

2026

2027

Basic economic parameters:

 

 

 

 

 

 

 

 

 

 

 

 

Real GDP growth

6.7

6.9

6.2

5.5

5.3

5.0

4.7

4.4

4.1

3.9

3.7

3.4

GDP deflator

-0.1

1.9

1.9

1.5

1.7

1.7

1.6

1.5

1.4

1.3

1.2

1.2

Nominal GDP growth

6.7

8.9

8.1

7.0

7.0

6.6

6.2

5.8

5.5

5.2

4.9

4.6

Nominal interest rate

3.9

3.5

3.2

3.1

3.1

3.1

3.1

3.1

3.1

3.1

3.1

3.1

Infrastructure Investment (trillion):

 

 

 

 

 

 

 

 

 

 

 

 

Budgetary amount

 

2.3

2.5

2.6

2.8

2.9

3.1

3.3

3.4

3.6

3.7

Total amount

 

12.1

13.1

14.2

15.3

16.4

17.8

19.2

20.7

22.4

24.2

Funding gap

 

5.3

5.8

6.3

6.9

7.5

8.1

8.7

9.3

9.8

10.4

Debt ratio

 

67.4

67.1

67.5

68.2

68.8

69.7

70.8

72.1

73.5

75.1

76.8

Deficit ratio

2.9

2.9

2.8

3.0

3.1

3.0

3.0

3.0

2.9

2.9

2.8

2.8

Fiscal revenue/GDP

34.7

35.9

34.8

34.0

33.2

32.4

31.6

30.8

30.0

29.2

28.4

27.6

Fiscal expenditure/GDP

37.6

38.8

37.6

37.0

36.3

35.4

34.6

33.8

32.9

32.1

31.2

30.4

Deficit ratio changes

 

 

-0.3

0.5

0.6

0.7

0.9

1.1

1.3

1.4

1.5

1.7

Debt auto trajectory

 

 

-3.1

-2.5

-2.5

-2.3

-2.1

-1.9

-1.7

-1.5

-1.3

-1.1

Contribution to interest rate

 

 

0.8

0.9

0.8

0.9

1.0

1.0

1.1

1.2

1.3

1.4

Contribution to GDP growth

 

 

-3.9

-3.4

-3.3

-3.2

-3.0

-2.9

-2.8

-2.7

-2.6

-2.5

NoteData unit is shown in (), data are sourced from Wind and the CEIC database.

 

Table 2: Dynamic trajectory and decomposed contribution

of debt ratio and deficit ratio 2016-2027 (Scenario 2)

 

 

Actual value         Estimated value

Year

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

2026

2027

Basic economic parameters

 

 

 

 

 

 

 

 

 

 

 

 

Real GDP growth

6.7

6.9

6.6

6.4

6.3

6.0

5.7

5.5

5.3

5.2

5.1

5.0

GDP deflator

-0.1

1.9

2.0

2.3

2.3

2.2

2.2

2.3

2.3

2.2

2.2

2.2

Nominal GDP growth

6.7

8.9

8.7

8.9

8.7

8.3

8.0

8.0

7.7

7.5

7.4

7.3

Nominal interest rate

3.9

3.5

3.2

3.1

3.1

3.1

3.1

3.1

3.1

3.1

3.1

3.1

Debt ratio

 

 

 

 

 

 

 

 

 

 

 

 

Scenario 2

 

67.4

72.4

77.3

81.8

86.4

91.0

95.4

99.6

103.8

107.6

111.3

Deficit ratio

 

 

 

 

 

 

 

 

 

 

 

 

    Scenario 2

 

9.2

8.8

9.0

9.2

9.1

9.2

9.1

9.0

9.0

8.8

8.7

Scenario 2

 

 

 

 

 

 

 

 

 

 

 

 

Deficit ratio changes

 

 

5.0

4.9

4.6

4.5

4.6

4.4

4.2

4.2

3.8

3.7

Debt auto trajectory

 

 

-3.4

-3.8

-4.0

-4.0

-3.9

-4.1

-4.1

-4.1

-4.2

-4.2

Contribution to interest rate

 

 

0.7

0.4

0.5

0.6

0.6

0.6

0.6

0.7

0.8

0.8

Contribution to GDP growth

 

 

-4.1

-4.3

-4.5

-4.5

-4.6

-4.6

-4.7

-4.8

-4.9

-5.0

Other changes

 

 

-0.3

-0.3

-0.6

-0.6

-0.6

-0.7

-0.7

-0.7

-0.8

-0.8

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Note: Data unit is shown in ().

Data source: Wind, CEIC database.

 

How to evaluate government debt risk

 

It is impossible to evaluate debt risk only by government deficit ratio or debt ratio. During 2008-2017, the fiscal deficit ratio of the US, Japan, UK, the Euro zone and India were 6.9%, 6.8%, 6.0%, 3.5%, and 7.8%, respectively. Among them, it was in the Euro zone with the lowest deficit ratio that the sovereign debt crisis occurred, while Japan with a debt ratio much higher than the rest of the countries did not experience any crisis. The above evidence shows that the correlation between deficit ratio, debt ratio and economic and financial risks is vague. Undoubtedly, governments should prevent the debt ratio from going too high. However, lower rate is not necessarily better. It is difficult to come up with a unified standard of appropriate debt ratio as conditions of countries differ. Based on other countries’ experience in managing government expenditure, when aggregate demand is insufficient, the government should expand spending, stabilize employment to avoid excessive economic downturn. Although these measures may increase government debts in the short term, they can save production loss caused by insufficient demand and benefit the growth of other sectors. When the denominator expands, total debt ratio of the whole economy may not necessarily rise.

 

A more practical approach to measuring debt risk is by the investment return of the projects. When evaluating debt risk, we should not only weigh debt but also the asset, and the return of the projects. If the invested projects will generate relatively good economic or social outcomes and benefit socio-economic development, despite the increase in government debt, government solvency will be improved. Though debt ratio is high, the risk is controllable. Conversely, if the invested projects are not beneficial to local socio-economic development, and there are no direct or indirect returns, although the debt ratio is low, solvency crisis is still a possibility.

 

Acknowledging historical debts and paying for newly-added infrastructure projects will not expand government expenditure and debts. After the global financial crisis, the Chinese government took a series of measures to maintain stable economic growth via massive investment expenditure. However, during 2008-2017, China’s average budgetary deficit ratio was only 1.5%, far below the 6-8% level of other countries. It was against that backdrop that local financing platforms began to amass debts and problems such as excessive borrowing, borrowing at excessively high cost, and opaque borrowing came to fore. Quick rise of overall debt ratio driven by local financing platforms has become the biggest concern for China’s economy. This is a typical example of how back door deals begin when the front door is shut. Setting clear boundary for local government debt and opening the front door will make fiscal debts and deficits explicit and standardized, and thereby enable more scientific management in the future. It is also conductive to maintaining macroeconomic stability, lowering socio-economic risks and reducing the real fiscal burden.

 

 
 
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