The World Bank has warned that Chinese local governments remain addicted to off-budget borrowing, despite Beijing’s efforts to impose fiscal discipline on localities and curb ballooning debt.
Runaway growth of local government debt is widely seen as a huge risk for China’s economy and financial system.
Provinces, cities and counties borrowed heavily to spend on infrastructure to keep economic growth humming after the 2008 financial crisis. But the practice has continued and economists warn that returns on new investment are falling and white elephants are common. Many projects do not produce enough cash flow to service their debt.
In 2014 China moved to eliminate borrowing through special-purpose vehicles, which local officials had used to circumvent a legal ban on direct borrowing. Under the moniker of “close the back door, open the front door”, China’s parliament ended the legal ban, enabling localities to borrow within clear limits set by Beijing.
Meanwhile, local government finance vehicles were ordered to cease disguised fiscal borrowing. To deal with legacy debt, Rmb8tn ($1.2tn) in outstanding LGFV borrowing was converted into on-budget provincial debt through a bond swap.
But growth of LGFV debt has actually accelerated since 2015, the World Bank warned in a confidential March presentation obtained by the Financial Times. Despite the swap programme, “LGFVs continued to borrow and increase their liabilities at a very rapid pace” in 2015-16, the bank’s lead China economist John Litwack and analyst Luan Zhao said.
Local governments and their LGFVs account for “the vast majority of public expenditures and public investment”, they noted, adding that “government and LGFV finances [are] intertwined in complicated ways, making separation difficult in practice”.
Growth of LGFV liabilities accelerated from 22 per cent in 2014 to 25 per cent in 2015 and stayed high at 22 per cent in the first half of 2016, the authors found.
The presentation noted that Beijing’s effort to stop the use of LGFVs as quasi-fiscal entities may have unintentionally encouraged them to increase borrowing. Local fiscal authorities are now forbidden from officially monitoring LGFV finances, since to do so would imply that the government stands behind their debt.
“Instructions to no longer even monitor finances of LGFVs can give a dangerous impression of ‘free money’,” the presentation warned.
The presentation accompanied a report on World Bank loans to the large inland province of Hunan and the megacity of Chongqing. The loans involved consultation and monitoring of local finances in those areas.
Two people briefed on the World Bank’s findings said the research on Hunan and Chongqing was unusual, as most local officials were not willing to open their books to international officials — or even to their superiors. They added that efforts to expand the Hunan provincial-level research to include individual counties had been rebuffed.
“Provinces have very limited information about the off-balance sheet finances of local governments,” the World Bank said in its March presentation.
In late April, China’s finance ministry issued a new order instructing local governments to resume monitoring the debt of LGFVs under their control
Despite the research findings that local debt growth remains high, at least some localities are moving to address the problem. In an unprecedented commitment, Hunan pledged to freeze public investment growth at 3 per cent through 2025, down from 16 per cent in 2015.
“Fiscal sustainability in Hunan will require phasing out public investment-driven stimulus policies in the near future,” the World Bank warned in a programme document in December.
World Bank China country director Bert Hoffman said: “We have been working very productively with Hunan province on developing the processes and rules needed to maintain fiscal sustainability,”
In a statement, Hunan said it had “drawn abundantly from the World Bank’s ripe experience in debt management”.